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On the Pricing of Step-Up Bonds in the European Telecom Sector

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This paper investigates the pricing of step-up bonds, i.e. corporatebonds with provisions stating that the coupon payments increase as thecredit rating level of the issuer declines. To assess the risk-neutral ratingtransition probabilities necessary to price these bonds, we introduce a newcalibration method within the reduced-form rating-based model of Jarrow,Lando, and Turnbull (1997). We also treat split ratings and adjust forrating outlook. Step-up bonds have been issued in large amounts in theEuropean telecom sector, and we find that, through most of the sample,step-up bonds issued by the two largest issuers have traded at a discountrelative to comparable fixed-coupon bonds from the same issuers. Ourfindings cannot be attributed to traditional liquidity factors, and they suggestthat issuing step-up bonds increased the cost of capital for the issuers.Keywords: defaultable bonds, step-up coupons, rating-based modelsJEL classification: G12, G13

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David Lando, Allan Mortensen

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