The Economics of Sustainability Linked Bonds

We develop a framework to understand the incentive structure and pricing of sustainability-linked bonds (SLBs). It provides conditions under which SLBs are incentive compatible for firms. We propose a novel mispricing measure for SLBs. Using the model and the mispricing measure, we derive and test several empirical predictions. We show that SLBs that are overpriced at issuance experience negative returns in the secondary market. The stock price reaction at issuance is significantly more positive for large and overpriced SLB issues with higher mispricing levels, consistent with a wealth transfer from bond- to shareholders. Finally, we document a significant relation between the mispricing measure and firms' ESG ratings.