Performance-Sensitive Debt

Abstract

This paper studies performance-sensitive debt (PSD), the class of debt obligations whose interest payments depend on some measure of the borrower’s performance. For example, step-up bonds compensate credit rating downgrades with higher interest rates, and reward credit rating upgrades with lower interest rates. In an endogenous default setting, we develop an algorithm to value PSD obligations allowing for general payment profiles, and obtain closed-form pricing formulas in important special cases, including step-up bonds. Moreover, we provide a criterion to compare different PSD obligations in terms of their efficiency. In particular, we find that step-up bonds lead to earlier default and lower the market value of the issuing firm’s equity, compared to fixed-coupon bonds of the same market value. Lastly, we analyze the implications of our results for the policy of credit-rating agencies.