Working Papers,
Copenhagen Business School, Department of Finance

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

JEL-codes: G12; G13

47 pages, November 12, 2004

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