On the Pricing of Performance Sensitive Debt

Abstract

Performance-sensitive debt (PSD) contracts link a loan's interest rate to a measure of the borrower's credit relevant performance, e.g. if the borrower's debt to cash ow ratio deteriorates, the interest rate increases according to a predetermined schedule. We derive and empirically test a pricing model for PSD contracts and nd that interest-increasing contracts are priced reecting the risk of shocks to the credit performance measure, implemented as shocks to borrower debt. Borrowers using such contracts are of higher credit quality compared to borrowers using interest-decreasing contracts, which are priced as if no shocks to borrower debt is present.

Keywords: Performance sensitive debt, credit risk, bank loans, structural debt model, empirical pricing

JEL Classification: G12, G13, G32