On the Pricing of Performance Sensitive Debt (Mjos A., Mykelbust T. A., Persson S.-A.)

Bank-Borrower Relationships Interest Rates Risk-taking and Risk Management

Abstract Performance sensitive debt (PSD) contracts link a loan’s interest rate to the borrower’s measure of credit relevant firm performance, e.g., if the borrower becomes less creditworthy, the interest rate increases according to a predetermined schedule. PSD provisions are included in approximately 35% of all U.S. and Canadian corporate loans (1994-2009, Thomson Reuters Dealscan). Based on standard no-arbitrage theory and observed contractual specifications, we derive and empirically test a new pricing model for PSD contracts with a cash flow driven performance measure. Our sample consists of 270 PSD loans where the loan contractual terms are collected from Thomson Reuter’s Dealscan database and the borrower information is collected from Compustat and CRSP. The theoretical market value of a PSD contract is on average 3:2% above par value at the time of issue. By considering the subsamples of only interest increasing and interest decreasing PSD contracts, respectively, we find that the former is overpriced by 7:7% on average, whereas the latter, on average, exhibits no significant mispricing. The empirically observed overpricing of interest increasing contracts is consistent with the signalling hypothesis of Manso, Strulovici & Tchistyi (2010) and the cost of moral hazard explanation of Asquith, Beatty & Weber (2005). The not significant mispricing of interest decreasing contracts is consistent with the idea that borrowers have increased bargaining power in the form of outside alternative financing options for these contracts.
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Libref/ Mjos A., Myklebust T. A., Persson S.-A. (2011) "On the Pricing of Performance Sensitive Debt", NHH Dept. of Finance & Management Science Discussion Paper No. 2011/5, pp. 1 - 48
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