We propose and test a valuation model for sustainability-linked bonds (SLBs)—debt instruments tying the cost of borrowing with corporate sustainability performance—considering the potential stochastic volatility nature of sustainability performance metrics. The model simulates multiple performance pathways to derived probabilities of them to meet their SLB targets and integrate these into the valuation of SLBs. Moreover, it incorporates the influence of issuers’ transition plans on these probabilities. Our empirical application validates the model’s effectiveness in providing investors with a dynamic tool to evaluate the sustainability commitments of issuers over time. This research enhances the understanding of bond valuation in the context of sustainability outcomes and informs decision-makers with a tool to identify potential misalignments in SLB pricing, offering an additional method of assessing the associated sustainability risks and opportunities.

This work was produced as part of CGFI’s Transition Finance Centre of Excellence partnership with Oxford Sustainable Finance Group. Funding for this work was provided by Santander Group through their support for the Transition Finance Centre of Excellence.