The promise of outcome-based finance is that capital markets will reward company performance on SDG targets and promote competition for the most effective sustainability solutions. In the long run, as investors continue to improve their understanding of how sustainability impacts financial analysis, the efficient market theory suggests that markets will “price” sustainability performance in the market for corporate bonds and equity. In the meantime, step-ups in the interest rates have been introduced to ensure that companies are sufficiently incentivized to meet their targets.
Arbitrage in the Secondary Market
Over time, bond (and equity) prices on the secondary market should reflect performance on material SDG targets. With the right incentives and information and the participation of all actors in the investment value chain, the bond market should reward performance key SDG metrics, just as it rewards performance on key business or financial metrics. If a company performs in line with its SDG targets, pricing would be in line with its credit rating. Higher performance would lead to higher bond prices and lower yield; under performance would lead to lower bond prices and higher yield.
Without adjustment mechanisms in the financial product itself, performance on SDG targets would not immediately impact the cost of a company’s outstanding debt. However, it would impact the cost of refinancing that debt or obtaining new financing.
The Use of Step-Up and Step-Down
Most sustainability-linked bonds and loans include a step-up mechanism in which interest rates increase if the issuing company fails to meet its SDG targets. While this feature has helped the rapid growth of outcome-based finance, the long-term growth and credibility of the market will require a meaningful variation in the financial characteristics of these instruments, likely beyond the current average of 34 basis points (see figure below).
Source: Moody's ESG Solutions, Environmental Finance Bond Database and company reports
Step-down and other structural adjustments have also been introduced. However, they are much less popular, especially in the bond market where the simplicity and standardization of instruments is critical.
