Should corporate debt include a rating trigger? |
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Authors: | Karan Bhanot Antonio S. Mello |
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Affiliation: | 1. Department of Finance, College of Business Administration, The University of Texas at San Antonio, 6900 North Loop, 1604 West, San Antonio, TX-78249, USA;2. Department of Finance, School of Business, The University of Wisconsin at Madison, 975 University Avenue, Madison, WI 53706-1323, USA |
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Abstract: | Recent corporate debt offerings have included a covenant specifying a pre-determined payment to debtholders when the debt is downgraded. We examine the incentive for equityholders to increase firm risk (and the associated costs) when debt includes a “rating trigger.” Equityholders of firms with a low-risk profile and operating flexibility choose debt with a trigger, while equityholders of firms with a high-risk profile and less flexibility choose regular debt. A trigger that requires an equity infusion better mitigates conflicts between equityholders and debtholders than a trigger paid by liquidating assets. A trigger that increases the coupon rate is not optimal. |
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Keywords: | G13 G32 G33 |
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