Final answer:
Sustainability matters in bond valuation as it can affect a corporation's risk profile and future performance. Sustainable practices can lead to better bond terms, and a lower cost of capital for the issuer. Investors consider these factors to estimate the present value of future expected payments and assess the risk of default.
Step-by-step explanation:
Corporate bonds are essentially loans that investors make to corporations, which in return provide a series of interest payments and the return of the principal at maturity. Sustainability has become an increasingly important factor in the valuation of bonds. This is because investors are becoming more sensitive to environmental, social, and governance (ESG) factors that can impact the long-term performance and risk profile of a company.
The risk associated with a bond, which includes the issuer's ability to make interest payments and return the principal, is a significant component in bond valuation. When evaluating corporate bonds, investors must assess whether the return is worth the risk, considering both the interest rate and the company's risk profile. If a company practices sustainability, it can positively influence the perception of its riskiness as a borrower, potentially leading to a lower cost of capital and better bond terms.
In the real-world, the price of a bond, which considers future expected payments, may be influenced by the risk of default (whether the borrower will repay) and changes in interest rates. However, the introduction of sustainability practices can alter an investor's expected returns calculation. An issuer that is deemed sustainable might be seen as having a lower risk of facing costly regulatory challenges, lawsuits, or resource limitations, which in turn could make their bonds more appealing to investors.