When do sustainability–linked bonds lower default risk? A correlation threshold

Issuers of sustainability-linked bonds (SLBs) face higher coupons or other negative consequences if a key performance indicator misses a sustainability target. Within a Merton-type model, we derive closed-form default probabilities for debt structures that incorporate SLBs and compare these probabilities to those associated with conventional debt. The comparison yields a critical correlation threshold ρ ∗ : If the correlation between asset values and the key performance indicator exceeds ρ ∗ , the SLB strictly lowers default risk. In typical cases that we examine, the correlation threshold is close to zero, and changes in default probabilities are rather small. • Sustainability-linked bonds (SLBs) penalize unmet sustainability targets. • We determine default probabilities when debt structures include SLBs. • The asset–key performance indicator (KPI) correlation affects outcomes. • If the asset–KPI correlation exceeds a threshold, SLBs reduce default risk. • Numerical results show that changes in default probabilities are small.