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

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, the authors analyze the optimal step-up bond design with respect to both frictions. They find that contrary to existing results, step-up bonds are indeed able to mitigate the asset substitution problem, the use of a step-up feature can be a credible signal to overcome asymmetric information problems, and the optimal designs as well as the conditions for the optimal use of step-up bonds are considerably different for the two explanations.