Valuing Euro Rating-Triggered Step-Up Telecom Bonds

Abstract

The coupon for a rating-triggered step-up bond is increased if the bond rating falls below a trigger value. In some cases, subsequent increases can occur if the rating deteriorates further; the coupon may also be reduced if the bond rating recovers. The step-up feature partially protects the bondholder against credit risk and also provides an added incentive for the issuer to maintain its credit rating. Despite the greater complexity of the bond's payout, by March 2001, step-up bonds accounted for more than 40% of the euro-denominated telecom bond market. Houweling, Mentink, and Vorst construct a valuation framework based on the Jarrow-Lando-Turnbull model of ratings transitions. Then, using three variants on their model, they explore how step-up bonds issued by six European telecom companies are priced in the market. The “risk-neutral” version of the model uses information from market prices on plain vanilla bonds from the same issuers, to capture the market premium for credit risk. The model then gives the marginal effect of the step-up provision. The authors find that bonds from different issuers seem to be priced differently in the market: some conform to the anticipated valuation, while others show no real difference in pricing between step-up and plain vanilla bonds.