Optimal Design of Rating Trigger Step-Up Bonds: Agency Conflicts Versus Asymmetric Information

In this paper, we analyze corporate bonds with a rating-triggered stepup provision in a continuous-time framework with bankruptcy costs and tax benefits. While without any further frictions, step-up bonds do not add firm value relative to straight debt, agency conflicts and asymmetric information are two possible explanations for the issuance of these instruments. We treat both motives (separately) in a unified framework to obtain conclusions about both the optimal design and the conditions for the use of step-up bonds. The closed-form solutions for the optimal contract design reveal that step-up bonds issued by firms that face a risk-shifting problem fundamentally differ from those in the case of asymmetric information. Furthermore, we show that firms with a high initial risk only use step-up bonds to overcome problems of asymmetric information but not to mitigate risk-shifting problems. A further difference between the two motives is that in the case of risk-shifting, step-up bonds are only used when the agency conflict is sufficiently severe, while for signalling reasons even a modest problem of asymmetric information supports the use of step-up bonds. JEL classification: G32, G13, C70