Working Paper Series, Department of Finance, Copenhagen Business School
David Lando and Allan Mortensen
On the Pricing of Step-Up Bonds in the European Telecom Sector
Abstract: 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; (follow links to similar papers)
JEL-Codes: G12; G13; (follow links to similar papers)
47 pages, November 12, 2004
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