Lando, David and Allen Mortensen, "On the Pricing of Step-Up Bonds in the European Telecom Sector", Journal of Credit Risk, Vol. 1, No. 1, (Winter 2004/05), pp. 71-110.
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 (1977). 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 calibration.
Previously tilted: "Mispricing of Step-Up Bonds in the European Telecom Sector"