Nº 22-26: The Economics of Sustainability Linked Bonds

We develop a conceptual framework to understand the incentive structure and pricing mechanisms of Sustainability-Linked-Bonds (SLBs). The model allows us to characterize the conditions under which an SLB is incentive compatible for a firm. We further derive a novel measure which identifies the extent of mispricing and potential wealth transfers between claim-holders at issuance. The model also allows us to compare the correct market yield of SLBs to the standard yield quoted by the industry. The comparison of the two yields suggests that the industry generally overstates the yield discount for firms that issue SLBs. The model generates several testable predictions. For instance, we provide evidence that SLBs which are overpriced according to our measure experience negative returns in the secondary market after issuance. We further show that for these overpriced bonds, the stock price reaction at issuance is significantly positive, which is consistent with a wealth transfer from bond - to shareholders Finally, we document a significant relationship between the mispricing measure and the issuing firms’ ESG ratings, a relationship that is complex and non-linear.