The design flaw in Sustainability-Linked Bonds

Auteur(s) :
Julien Lefournier

We examine in this paper sustainability-linked bonds (SLBs) whose issuance now totals more than USD 200 bn. A typical SLB has a coupon step-up linked to the issuer achieving a predetermined sustainability performance target. First, we recall why a SLB and a counterfactual vanilla bond issued by the same borrower should be and actually are priced with the same issuer yield.
Our analysis then shows that the SLBs parameters (mainly step-up period as a fraction of the bond’s tenor, coupon step-up size and step-up activation probability) cannot be manipulated to lower the issuer’s cost of capital significantly, which is presumed to be the very goal of the SLB product. There is a structural design flaw in the SLB mechanism: setting a significant coupon step-up does not suit the issuer’s nor the investors’ interests, considering conditionality. This creates a no win situation for the issuer and investors alike and explains the “benign” use of SLBs by current market participants.