8. Valuing Bonds

A bond certificate indicates the amounts and dates of all payments to be made. Payments are made until the final repayment date, known as the maturity date of the bond. The time until the maturity date is known as the term. Bond maturities or terms range from very short term (months) to decades or even perpetuity. There are still some bonds outstanding that were issued centuries ago. Two types of payments are made on a bond:

For example, a bond with a face value of €1000 and a 3% coupon (payable annually) will make coupon payments of €30 every 12 months: €1000 * 0.03 = €30. Some bonds do not pay coupon payments. Such bonds are known as zero-coupon bonds and can still offer the same return as coupon paying bonds, by offering the same principal at a lower price.

Whereas bonds are public debt, bank loans and private debt placements are types of private debt. Figure 8.2 classifies bonds by the identity of the issuer, with the main distinction being between government and corporate bonds as the latter carry more serious default risk.

A block diagram classifies debts into bonds of public debt and private debt. The bonds are further classified into government bonds and corporate bonds. Corporate bonds are further classified into secured corporate bonds and unsecured corporate bonds.

Government or sovereign bonds are issued by national governments (i.e. countries). The main distinctions within corporate bonds are those between company issuers and financial sector issuers and between secured and unsecured bonds. The financial sector accounts for a very large part of the corporate bond market (see Table 8.1). In the remainder of this chapter, we focus on government bonds and corporate bonds issued by companies.

Secured bonds entail specific assets that are pledged as collateral and to which bondholders have a direct claim in the event of bankruptcy. An example is mortgage bonds, which are bonds secured by a pool of mortgages on real estate. Unsecured bonds have lower seniority or priority. In the event of bankruptcy, holders of unsecured bonds have a claim only to the assets of the company that are not already pledged as collateral on other (secured) debt.

In principle, bond prices result from discounting a clear pattern of promised cash flows. The price or value of a coupon bond P equals the present value of all its coupons plus the present value of the face value of the bond with maturity N. The formula is as follows:

where YTM_n is the yield to maturity of a zero-coupon bond (a bond without coupons) that matures at the same time as the n-th coupon payment; CPN is the coupon payment; and FV is the bond’s face value, which is typically denominated in standard increments of €1000 or $1000. Bond prices and yields are inversely related. It follows from Eq. (8.1) that a lower yield produces a higher bond price and vice versa. Given that one knows the coupon and face value of a bond, one needs only the price (the yield) to calculate the yield (the price). Below we give examples of both: calculating the yield to maturity (Example 8.1) and calculating the price (Example 8.2). These examples show that once you know one (the yield or the price), you can calculate the other one (the price or the yield).

The coupon payment is determined by the annual coupon rate ACR and the number of coupon payments per year Nr:

A €1000 bond with a 5% coupon rate and annual payments pays a coupon of €50 = 5% * €1000/1 every year. A €1000 bond with a 6% coupon rate and semi-annual payments pays a coupon of €30 = 6% * €1000/2 every 6 months.

The coupon payments form a stream of equal cash flows paid at regular intervals. In Chap. 4, we call this an annuity (see Eq. 4.​7). The present value of the bond then becomes the sum of the ‘coupon annuity’ and the face value. The rates (yields) at which the cash flows need to be discounted do vary, as interest rates fluctuate over time. The yield to maturity (YTM) or just the yield (y) on a bond is the discount rate that sets the present value of its payments equal to its current market price. More formally, the price of a bond P is:

where y is the yield of this particular bond and reflects the yield received if all coupons received are reinvested at a constant interest rate. Put another way, the yield is the IRR (internal rate of return) of a bond. Market forces keep this relation intact: as interest rates and bond yields rise, bond prices fall, and vice versa. This means that bonds trade at times at a premium (at a price greater than face value), at times at a discount (at a price lower than face value), and very occasionally at par (at a price equal to face value).

As stated, interest rates fluctuate and bond prices move along with them. Equation (8.3) shows that if the yield y increases by 1% the effect is larger for a long-term bond than for a short-term bond. This can easily be seen by comparing Eq. (8.3) with N = 1 to that with N = 2 . So longer-term bonds are more exposed to interest rate fluctuations. It is possible to derive an exposure measure to interest rate/yield fluctuations, which is called duration. The duration of a bond is the sensitivity of a bond’s price to changes in interest rates. Duration is the weighted average of the time-length of the cash payments. The time-length is the number of future years n = 1, 2, 3, . . , extending to the final maturity date N. The weight for each year is the present value of the cash flow in that year PV(CF_n) divided by the total present value PV of the bond.

The duration is higher for bonds of longer maturity, since more of their cash flows are further in the future, and thus more affected by discount rates. Table 8.2 calculates the duration of 6-year bonds with an annual coupon of 5% and a yield of 4%. The present value PV of the cash flows of each year add up to the total present value PV of €1057.7. Then we calculate the PV of each year’s cash flow as a fraction of total value and multiply each fraction by the year in which that cash flow takes place. The outcomes (see bottom line of Table 8.2) add up to a duration of 5.3 years. As the final payment is relatively large (coupon + face value) and counts heavily (multiplied by year in which discounted), a bond’s duration is close to the bond’s maturity. In Table 8.2, the duration of 5.3 years is close to the bond’s maturity of 6 years. The duration is a good measure of the interest rate risk of a bond. A higher duration (‘weighted maturity’) reflects higher interest rate risk.

There are several explanations for a positive term premium:

So, the first two reasons for a positive term spread concern (the risk of) higher future interest rates. The third reason is about risk-averse investors demanding a premium for inflation risk. Inflation \( {i}_{i,t}=\frac{\left(\ {CPI}_{i,t}-{CPI}_{i,t-1}\ \right)}{CPI_{i,t-1}} \) is the realised consumer price index (CPI) inflation rate in a given country i and year t. Inflation can and does differ across time and across countries. It is therefore helpful to compare yields or more generally returns in real terms r_r. The real rate of return can be calculated as:

By re-arranging, we can express the Inflation-adjusted real returns r_r for an asset class as:

We can use the approximation for real interest rates in the form of nominal return minus inflation r − i in low inflation countries. If the nominal rate is 4% and inflation is 1%, the real rate of return is approximately 3 %  ≈ 4 %  − 1%. The exact real interest rate is 2.97%. For high inflation countries, we’d better use the full formula, since larger numbers result in larger deviations.

Notwithstanding these forces for a positive term premium, a downward sloping yield curve (called inverse yield curve) is also possible. A major reason for an inverse yield curve is increased expectations of a recession, where central banks are likely to reduce interest rates to foster economic growth.

National government bonds, also known as sovereign bonds, have been issued for centuries and their prices have tended to be driven by (expectations regarding) the fortunes of the states involved and their reliability in paying back their debt. In fact, Ferguson (2001) argues that Britain beat France in the struggle for colonial empire in the 1700s, as the British managed to finance their wars at low interest rates, thanks to reliability in repaying debt and an efficient bureaucracy. France’s cost of funding was consistently higher due to its poor reputation in repaying debt.

Nowadays, countries have formal credit ratings, set by credit rating agencies (as explained in Sect. 8.3 below). In an empirical study of the determinants of sovereign credit ratings, Cantor and Pecker (1996) find that credit ratings and sovereign borrowing costs can be explained by per capita income, GDP growth, inflation, external debt, the level of economic development, and default history. Government bonds are typically bought by institutional investors, who seek a relatively safe investment. Insurance companies and pension funds have large holdings of government bonds to hedge the interest rate risk of their liabilities with safe assets. Government bonds by the same issuer (or by an issuer with the same rating) may still have different prices, driven by differences in maturity and liquidity.

Different dynamics may occur during economic crises, with a prominent role for financial contagion (Beirne & Fratzscher, 2013). Financial contagion is the spread of market disturbances from one market or country to other markets or countries. A salient example is the European Sovereign Debt Crisis, which started in Greece at the end of 2009. After several revisions of previously announced deficit figures (even going back to the time of admission of Greece into the Euro area) had been published it became clear that public finances in Greece were unsustainable. On 10 May 2010, the 10-year yield spread between Greek and German government bonds reached about 10% (outside the range of Fig. 8.4). Similar concerns arose in Ireland, Portugal, and, later, Spain and Italy. Figure 8.4 shows that the Italian 10-yield spread went up to 5% in late 2011 (7% for Italy minus 2% for Germany). Again, the Italian yield spread reached 3% in 2018/2019, due to concerns about political stability in Italy.

A line graph of in percent versus January 08 to January 22 plots 4 fluctuating lines for Germany, France, Netherlands, and Italy. The line for Italy is above all other lines. The time between January 10 and January 13 is shaded.

The European Sovereign Debt Crisis reconfirmed the status of the German bond as benchmark bond. The German bond yield can thus be used as the risk-free rate for the Euro (see Chap. 13). The yield curves of two other very creditworthy countries, France and the Netherlands, are just above the German yield curve in Fig. 8.4. Similarly, the US Treasury yield serves as the risk-free rate for the US dollar. US government bonds are called Treasuries. These German and US government bonds are the most creditworthy and liquid bonds in their respective currencies.

Corporate bonds differ from sovereign bonds in some important respects. The most important differences are that corporate bonds tend to carry more serious default and liquidity risks. Liquidity risk refers to the lower trading frequencies, higher transaction costs due to lower competition among bond traders, and smaller sizes of corporate bonds, which make it harder to trade such bonds. Given that corporates are (much) smaller entities than governments and cannot tax people, they are also much more likely to default (i.e. be unable to meet their payment obligation).

Such default risk, or credit risk, means that the bond’s expected return, which is equal to the firm’s cost of capital, is less than the yield to maturity YTM on the promised payments. Equation (8.8) below gives the mathematical relationship between the yield to maturity (i.e. the promised rate) and the expected rate. Figure 8.5 illustrates the difference between these two rates.

A grouped bar graph plots the percentage values for the expected return and the yield to maturity of government bonds and corporate bonds. The values of the bars in government bonds are 2.0% and 2.0%. The values of the bars in corporate bonds are 2.5% and 3.0%.

The reason for the difference is that the expected payments are lower than the promised payments, if there is a risk of default. So a higher YTM on bond X than on bond Z does not necessarily imply that the expected return on X is higher than on Z. The yield spread is the difference between yields of corporate bonds and yields of government bonds and reflects the default and liquidity risks. The higher the default (and liquidity) risk, the larger the spread will be. This spread can be calculated for all maturities and be expressed in the so-called corporate yield curve. Figure 8.6 shows the 10-year yield curves (in basis points) and Table 8.3 the yield spread (in percent). Note that 100 basis points is equal to 1%.

A line graph of in-basis points versus maturity in years plots 3 lines for A A A corporate bonds, A corporate bonds, and A A A treasuries. The line for A corporate bonds is above other lines. The line for A A A corporate bonds follows an increasing trend and other lines fluctuate gradually.

Several drivers of yields have been identified, some of them a long time ago. Fisher (1959) finds that default risk is the prime determinant of yield spreads on corporate bonds and that liquidity or marketability is the second most important determinant. Cohan (1962) finds the following additional (and related) drivers: rating (essentially an assessment of default risk), type of bond, and maturity. Of course, these factors are related to each other to some extent. For example, larger firms tend to have more stable cash flows, lower default risk, larger issues, and higher ratings. Section 8.4 shows that there is also evidence that yields are affected by sustainability factors.

Now it’s time to formally introduce the concepts of credit and liquidity risk. Credit risk refers to the risk of default of the government or company issuing a bond. The expected return on a bond is different from the promised return or yield y on bonds, as some issuers default on their bond. The expected return on debt r_D can be calculated as follows:

where PD is the probability of default and LGD the loss given default (the fraction of the principal and interest lost in case of default). Historically, the loss given default rate is about 60% for unsecured bonds (S&P Global Ratings, 2020b). Equation (8.8) can be illustrated with a simple example. Assume a promised yield of 6%, a probability of default of 4%, and a loss given default of 60% (which means that 40% is recovered). The expected return is 3.6%, calculated as 6 %  − 4 %  ∗ 0.60 = 3.6%.

where EAD is exposure at default. Equation (8.9) gives the formula for expected credit losses. In the case of bonds, the exposure at default is the principal and interest payment. The expected credit losses in our bond example are 2.4%, calculated as: 1 ∙ PD ∙ LGD = 1 ∗ .04 ∗ .60 = 0.024. This 2.4% expected loss is the difference between the promised yield at 6% and the expected return at 3.6%.

The next step is to calculate the reward for risk taking: the credit risk premium or CRP. Just like the market risk premium (Eq. 12.​13) introduced later in Chap. 12, the CRP is the difference between the expected return on a bond E[y] and the risk-free rate r_f:

As discussed, the risk-free rate can be derived from the government bond yield curve. Assuming a risk-free rate of 2%, the credit risk premium is 1.6%, calculated as 3.6 %  − 2 %  = 1.6%. Now that we have derived the separate items in Eqs. (8.8) and (8.9), we can introduce the overall concept. The credit spread is the difference between the promised yield y and the (risk-free) government yield r_f. In our example, the credit spread is 4%, calculated as 6 %  − 2 %  = 4%. The credit spread covers the expected credit losses at 2.4% (that are a function of the probability of default PD and the loss given default LGD in Eq. 8.9) and the reward for risk taking on the bonds at 1.6% (that is the credit risk premium from Eq. 8.10). Figure 8.7 summarises the components of corporate bond yields: the risk-free rate, the credit spread, and the liquidity spread (see Sect. 8.3 below). Example 8.5 shows how to compute the expected return and credit risk premium.

A stacked block diagram. The layers from the top are expected liquidity costs, liquidity risk premium, expected credit losses, credit risk premium, and risk-free rate. The first 2 layers depict liquidity spread and the next 2 layers depict credit spread. The top 4 layers together are yield spread.

Bond ratings are assessments of the possible risk of default, prepared by independent private companies that specialise in such ratings. Credit ratings are there for efficiency reasons: it is inefficient for every investor to privately investigate the default risk of every bond. Instead, a limited number of credit ratings agencies assess the creditworthiness of bonds and certify the issuers. They make this information available to investors, who can decide whether to do additional work on assessment. The best-known credit rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch. A major governance issue is that credit ratings are paid by the issuer and not by the investor, which creates a conflict of interest.

Credit ratings are typically classified as investment-grade (the top four ratings categories, with low default risk) or junk/high-yield/speculative (the bottom five categories, with high likelihood of default). Box 8.1 provides an overview of bond ratings, with long-term average default rates (PD from Eq. 8.8). The mandate of institutional investors often allows them only to invest in investment-grade bonds. This increases the demand for these bonds, resulting in higher bond prices and lower yields.

A company that has bonds outstanding also has equity. In fact, owning the equity of a company is like having the right to buy the company (an option) paying the face value of debt to the bondholders. And the more debt there is, the riskier that right becomes (Merton, 1974). Equity holders have much more upside risk than bondholders. A benefit for bondholders is that they get paid back first in case of default. While both parties benefit from higher profits and growth, equity holders benefit from volatility (risk), while bondholders suffer from volatility or uncertainty. This may give rise to a conflict of interest between equity holders and bondholders.

The presence of debt may, for example, cause an underinvestment problem. In this situation equity holders have no incentive to invest new capital, not even in positive NPV projects: as the company is highly levered, equity holders know the payoffs go to bondholders anyway. Myers (1977) has shown the ‘debt overhang’ problem formally: if management is aligned with equity holders (for example, via variable compensation in stocks), it will only attract new capital for projects that have returns that are high enough to pay back not just bondholders, but to leave a residual return for shareholders as well.

The situation is different if there is already capital in the company (e.g. through retained earnings), and an overinvestment problem might occur. Equity holders might prefer risky investments in negative NPV all-or-nothing projects in which their expected payoff is higher (equity holders get the full upside, and only part of the downside), but the expected payoff of the bondholders is lower (bondholders get most of the downside). These risk-shifting situations increase the value of equity at the expense of bondholders.

There are ways of limiting agency conflicts. An example is including covenants that protect the interest of bondholders and limit the decisions of management, say when a certain threshold profitability or threshold debt-to-equity ratio is crossed. But there are also costs, called monitoring costs, related to such arrangements. Shareholders will want to limit those monitoring costs, as they ultimately bear most of them as residual claimants. In case of default, bondholders bear them. Shareholders can disclose information (for example, on the financial expectations of large operations in the annual report) to facilitate the work of control. For that information to be credible, its accuracy has to be verified by independent outside auditors. This results in bonding costs: the costs of providing information, contracting auditors, and self-imposed restrictions such as covenants. Smith and Warner (1979) list a number of bond covenants: restrictions on investment policies, restrictions on dividend payments, restrictions on subsequent financing, and the modification of patterns of payoff to the bondholders, for example convertibles or callability provisions.

Bondholders rely on delegated monitoring and have little control over the issuer. Debt holders typically have no voting power, except when the company goes bankrupt. As the original equity is then wiped out, the debt holders become the ‘owners’ of the company. In bankruptcy, debt is turned into equity. Such control transfers do not happen very frequently, and they may not be very swift.

Bonds also face liquidity risk, which is the risk that bonds cannot be sold swiftly. Liquidity is the ease with which an investor can sell or buy a bond immediately at a price close to the mid-quote (i.e. the average of the bid-ask spread, see Box 8.2). The spread between the yield of a bond with high liquidity and a similar bond with less liquidity is referred to as the liquidity premium. The higher liquidity risk of corporate bonds stems from lower trading frequencies and higher transaction costs. That is due to the smaller sizes of individual corporate bond markets (i.e. per security) and less competition among bond traders.

In Europe, Germany is one of the most creditworthy countries. Germany has one major advantage over other creditworthy countries like Finland and the Netherlands: the German government bonds form the deepest market (the most liquid) and serve as benchmark for the Euro-yield curve. In the USA, the US Treasury is the benchmark for the US-dollar-yield curve.

Sustainability matters for bond valuation, as sustainability issues include value relevant issues that are not yet properly priced (inefficiencies). As in equities (Chap. 9), sustainability analysis is a natural extension of fundamental bond analysis, providing the link between valuation and material environmental and social factors. Bond analysis is also called fixed-income analysis, given that the income of bonds is ‘fixed’ (just the contractual interest payments). Compared to equity, the focus in fixed-income valuation is much more on risk than opportunities, except perhaps in high yield. The reason is that bondholders are mainly exposed to downside risk and benefit much less from upside potential than shareholders do.

Some fixed-income investors are equally, if not more concerned than equity investors about environmental and social exposures. These exposures can have pronounced effects on performance by generating risks that may materialise in both going concern and default scenarios. For example, as the Dieselgate scandal hit Volkswagen in September 2015, its CDS spread rose from 75.5 basis points (bp) on 17 September to 299.5 bp on 28 September (the CDS spread is the credit default swap spread, which measures the credit spread on a bond). This can also happen with governments. After Russia seized the Crimea from Ukraine in 2014, the Russian 5- and 10-year CDS spread rose from a 200–300 bp range to spike over 600 bp. Ukraine’s CDS spread spiked at over 5000 bp. Figure 8.9 visualises the materiality of environmental and social factors to bonds. The underlying factors differ slightly when comparing governments to corporates (Table 8.4).

A horizontal arrow diagram. The labels from the left are environmental and social factors, factors influencing creditworthiness, and credit risk indicators.

All of the issues mentioned in Table 8.4 merit a paragraph by themselves, but that is beyond the scope of this chapter. It is striking that many issues are relevant for both corporate and government bonds, especially on the environmental side. The environmental side is also better developed than the social side, in terms of both data and impact investing. The green bond market has, for example, taken off while the social bond market is very small (see Sect. 8.6). Because of the data and nature of the issues, it is much more difficult to decide which companies are part of the solution and which are part of the problem when dealing with social issues compared to environmental issues. The remainder of this section focuses on integration of sustainability into corporate bond analysis, as this book is focused on corporate finance. For the integration of sustainability into government bonds, see Schoenmaker and Schramade (2019).

Advanced credit risk assessment models estimate the probability of default PD and the loss given default LGD on the basis of historical data at industry and company level. Equation (8.9) in Sect. 8.3 provides the formula:

It is a challenge to integrate sustainability due to its forward-looking nature (see Chap. 12). The prospect of forced internalisation of social and environmental externalities affects credit risk. Companies that internalise social and environmental factors (and are thus well prepared for the sustainability transitions) can reduce their credit risk. Chapter 2 discusses how companies can adapt their business model to transitions. A high adaptability a (from Eq. 2.​1) reduces the probability of default PD and the loss given default LGD. By contrast, a low adaptability increases credit risk, as the company has less chance of survival in our changing world. It is therefore important to integrate into credit risk analysis:

Example 8.6 illustrates the increased credit risk of an oil company that fails to adapt.

There is academic evidence that sustainability measures improve credit rating predictability (Dorfleitner et al., 2020). Companies with higher sustainability scores have better credit ratings, which supports the risk-mitigation view. Sustainability or ESG integration into credit ratings has grown over the last years. Yet, such integration is still limited, as it typically just reflects an adjustment for ESG factors. Such efforts do not fully account for social and environmental externalities, and staying within planetary and social boundaries, as in Example 8.6 above.

Credit rating agencies are stepping up their sustainability integration by acquiring sustainability data providers. S&P, for example, bought Trucost, a provider of carbon and environmental data and risk analysis, in 2016.

Green bonds are a recent and fast-growing phenomenon. Similar to green loans, their purpose is to finance green projects, such as those that reduce greenhouse gas emissions or increase recycling. The first green bond was issued by the European Investment Bank in July 2007, and it took 6 years for the green bond market to pass $10 billion in cumulative issues. The market has grown exponentially in recent years, reaching global annual issuance of $520 billion in 2021 (Fig. 8.12). At first, the market was dominated by supranationals, which are supranational or multilateral government agencies, such as the World Bank, the International Monetary Fund, the Inter-American Development Bank, the Asian Development Bank, or the European Investment Bank. Since 2012 other types of issuers, including agencies, sovereigns, corporates, municipalities and financial institutions, have been involved. Related products were also launched, including green bond funds and green bond indices. Market-based standards followed suit, including the Climate Bond Standards in November 2010 and the Green Bond Principles in January 2014. The European Commission produced a draft EU Green Bond Standard in 2021.

A bar graph estimates the market value of issuance per year in billion dollars versus the years from 2007 to 2021. The values increase gradually over the years. The highest bar is at (2021, 520). Values are estimated.

In principle, green bonds provide environmental or climate change benefits, but are otherwise the same as other bonds. The vast majority (90%) of the green bonds issued are investment-grade bonds (Zerbib, 2019). Institutional investors that pursue sustainable investing policies can buy these investment-grade bonds. Box 8.3 describes the criteria for a green bond.

The green bond market is growing fast but it faces some serious challenges. For example, there is no clear agreement on what constitutes a green bond. There are several standards and numerous interpretations of those standards. As discussed, there are plans for developing official European sustainability standards for green bonds. Green bonds also require better investor communication. Many investors do not know how green bonds work, what the costs are, and whether they stay within planetary boundaries. Demystifying those issues could help to broaden the investor base.

Green bonds are not suitable for complex transactions. Waste management company Renewi used bank finance for its merger with Van Gansewinkel rather than coming back to the green bond market. Companies also face reputational risk by issuing a green bond, as it may not be recognised as such. In 2015, Unilever issued a £250 million green bond that was excluded from the Bloomberg Barclays MSCI Green Bond Index.

Social bonds are bonds that are meant to provide clear social benefits. They are a payment by results contract, with which an organisation, typically one with a social purpose, agrees to deliver a certain outcome on a social project. If the objectives are not achieved, investors receive neither a return nor repayment of the principal. In that respect, social bonds are different from regular or green bonds, where the principal needs to be repaid.

So far, the market for social bonds is less developed than the green bonds market. The UK is leading the way in this regard. The Peterborough social bond is the world’s first, established in 2012. It intends to invest £5 million in reducing the reoffending rate in prisoners leaving Peterborough prison. Another early social bond is the £10 million charity bond by Triodos, Golden Lane Housing and Mencap, which is meant to buy homes for people with learning disabilities.

The Social Bond Principles (ICMA, 2021b) define a social bond as ‘any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance in part or in full new and/or existing eligible social projects and which are aligned with the four core components of the Social Bond Principles’. That means that, as with green bonds, the bonds are earmarked but not ring-fenced, for social projects. Hence, they bear the same risk as otherwise similar bonds of the same issuer. The Social Bond Principles have the same four core components as the Green Bond Principles, described in Box 8.3.

Just as with green bonds, there is no clear agreement on what exactly constitutes a social bond. However, the Social Bond Principles do give an indication of what eligible social projects look like. Social project categories include, but are not limited to: affordable basic infrastructure; access to essential services; affordable housing; employment generation; food security; socioeconomic advancement, and empowerment. But of course, one could argue just what fits in these categories.

For further guidance, the Social Bond Principles also state that examples of target populations include those living below the poverty line; excluded/marginalised communities; vulnerable groups; migrants or displaced persons; the undereducated, underserved, and unemployed. Whatever the project may be, the principle is very clear: it should provide clear social benefits. Social bonds have been criticised for being complex, expensive, and bureaucratic. It has been hard to create accurate measures of social results.

In addition to green and social bonds, several types of ‘sustainable’ bonds are emerging at the time of writing. Sustainability Bonds are bonds where the proceeds are exclusively applied to finance or re-finance a combination of green and social projects.

Sustainability-linked bonds can be used for the issuer’s general purposes. These bonds incorporate measurable forward-looking sustainability key performance indicators (KPIs) and sustainable performance targets. Improvement in the sustainability KPIs leads to lower interest rate payments (i.e. a lower yield), and vice versa. The price of these sustainability-linked bonds thus includes the market’s assessment of the expected sustainability performance of a company. Remember that higher bond prices reflect lower yields and lower bond prices higher yields (see Sect. 8.1). Table 8.5 provides an overview of the sustainable bond market.

While the different types of green, social and sustainability bonds can play a useful role in the build-up of a company’s sustainability credentials (Flammer’s (2021) signalling argument), it is expected that, just like credit analysis, sustainability analysis will be fully integrated into investment analysis. The overall sustainability performance of a company is then relevant for determining the yield on that company’s bonds. In that way, sustainability-linked bonds are the way forward, because they link a company’s cost of debt to its overall sustainability performance.