Notes on Risk-Neutral Pricing of SLBs and Step-down Structures

This paper analyses Sustainability-Linked Bonds (SLBs) through a risk-neutral present value scenario approach. By assuming that the discounted, probability-weighted cashflows in an SLB should equate to those of an equivalent vanilla bond (EVB), several conclusions around this new type of financing instrument are derived. We show how, in a risk-free setting, a step-down SLB must by necessity offer a coupon above that of the equivalent vanilla bond, and vice versa for step-ups. The model also allows us also to back-out – holding other variables fixed - market-implied step-up probabilities and can alternatively be used to adjust a structure to accommodate a sought-after lower cost-of-capital for the issuer. Expanding the model to include various risk perceptions: we show that the dynamics change such that a step-down SLB may actually price with a coupon lower than a traditional bond, if the sustainability linkages are correlated with improved credit quality/higher repayment probabilities. We illustrate this by calibrating a step-down SLB to rating based spread curves.5

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