The Pricing of Sustainability-linked Bonds: An Empirical Investigation

Abstract

The market for Sustainability-Linked Bonds (“SLBs”) is one of the fastest-growing corners of sustainable finance. With less than five years into its growth journey, a lot remains to be understood about the novel structure of such bonds and in particular, the naturally inherent optionality value. Through an empirical investigation of their pricing in the primary and secondary bond markets, this paper contributes to the scarce literature by examining the current pricing dynamics of corporate SLBs.
Through an assessment of matched bond pairs, we find that SLBs are issued at a premium averaging 12.3 bps relative to their conventional peers. Yet, we find that this pricing discrepancy cannot be explained by the ESG characteristics that are unique to SLBs, thereby providing evidence that the ESG option value is not priced correctly at issuance. Even when asserting zero probability to the target(s) being met and thus, letting the option materialize with certainty, the financial savings from issuing SLBs at a premium far exceed the penalty imposed. Having concluded that this price discrepancy is not directly attributable to the ESG option, we find that such overpriced SLBs underperform immediately post issuance, indicating that a price correction takes place in the secondary bond market. Combined with a positive stock market reaction to such issuances we argue that issuing SLBs at a premium induces a wealth transfer from bond- to equity holders. Our results in the primary bond market provide evidence for the cost of capital argument as a rationale for issuing SLBs. We find no evidence that SLB issuances serve as a credible signal of firms’ commitment to sustainability but argue that such issuances are associated with a greenwashing risk.
Post issuance, we find no evidence that our full sample of SLBs trade at significantly different levels to their conventional peers, though a premium might continue to exist on certain types of SLBs. Regardless of its significance, any price discrepancy post issuance cannot, however, be explained by the ESG characteristics unique to SLBs. Our results thus speak to the difficulty in assessing the value of the ESG option inherent in SLBs, leading its perceived value to approach zero in the secondary bond market.