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Abstract:
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This paper investigates the pricing of step-up bonds, i.e. corporate
bonds with provisions stating that the coupon payments increase as the
credit rating level of the issuer declines. To assess the risk-neutral rating
transition probabilities necessary to price these bonds, we introduce a new
calibration method within the reduced-form rating-based model of Jarrow,
Lando, and Turnbull (1997). We also treat split ratings and adjust for
rating outlook. Step-up bonds have been issued in large amounts in the
European telecom sector, and we find that, through most of the sample,
step-up bonds issued by the two largest issuers have traded at a discount
relative to comparable fixed-coupon bonds from the same issuers. Our
findings cannot be attributed to traditional liquidity factors, and they suggest
that issuing step-up bonds increased the cost of capital for the issuers.
Keywords: defaultable bonds, step-up coupons, rating-based models
JEL classification: G12, G13 |
This work is licensed under a Creative Commons License.
