Optimal design of rating-trigger step-up bonds: Agency conflicts versus asymmetric information

Abstract

Agency conflicts and asymmetric information are two possible explanations that may rationalize the use of a step-up provision in the bond indenture. Within a continuous-time framework with bankruptcy costs and tax benefits, we analyze the optimal step-up bond design with respect to both frictions. We find that (i) contrary to existing results, step-up bonds are indeed able to mitigate the asset substitution problem, (ii) the use of a step-up feature can be a credible signal to overcome asymmetric information problems, and (iii) the optimal design as well as the conditions for the optimal use of step-up bonds is considerably different for the two explanations. This outcome implies that, based on observable firm and bond characteristics, it is possible to discriminate between the two motives underlying the use of step-up bonds.