This paper studies performance-sensitive debt (PSD), the class of debt obligations whose interest payments depend on some measure of the borrower’s performance. For instance, step-up bonds compensate credit rating downgrades with higher interest rates and credit rating upgrades with lower interest rates. The vast majority of PSD obligations charge a higher interest rate as the borrowers performance deteriorates. We refer to such obligations as risk-compensating PSD obligations.

This paper addresses two questions. Why do firms issue PSD obligations? How to value PSD obligations? We propose a method to price PSD obligations and use it to prove that, in a setting with no market imperfections other than bankruptcy costs and tax benefits of debt, risk-compensating PSD schemes have an overall negative effect on the issuing firm. Thus, the existence of risk-compensating PSD obligations cannot be explained by the popular trade-off theory of capital structure and should be explained by other market frictions. We show that PSD obligations can be used as a screening device in a setting with asymmetric information. Using data on loan contracts between 1995 and 2005 from Thomson Financial’s SDC database, we find that firms whose loans have performance pricing provisions are more likely to be upgraded and less likely to be downgraded one year after the closing date of the loan than firms with fixed interest loans.

Our paper builds on Leland (1994), in which the firm’s equityholders choose the default time that maximizes the equity value of the firm. We model performance-sensitive debt as a function C : ? ?? R+ mapping some performance measure ? to the interest rate C(?). In this setting, the equity value associated with a given PSD profile satisfies an ordinary differential equation. We obtain closed-form pricing of PSD in important special cases, including step-up bonds with an arbitrary number of rating triggers. Considering general diffusions allows one to model such stochastic features as mean-reversion of the cash-flow process or the negative relation between cash-flow volatility and level.

For PSD obligations C and D that are based on the same performance measure, we say that C is more risk-compensating than D if C ?D is non-increasing and non-constant. We prove that if C and D raise the same amount of cash, and if C is more risk-compensating than D, then C is less efficient than D, in the sense that C induces an earlier default time, which means a higher present value of bankruptcy costs and lower equity equity value. In particular, a PSD obligation is less efficient than a debt obligation with a fixed interest rate of the same market value.

To explain the existence of risk-compensating PSD, we develop a screening model, in which the future growth rate of the firm is unknown to the market, but known to the firm’s manager. We demonstrate that there exist separating equilibria, in which the high-growth firm issues a risk-compensating PSD obligation, while the low-growth firm issues fixed-interest debt. The low growth firm does not want to mimic the high-growth firm because for a given risk-compensating PSD obligation the low-growth firm will likely pay higher interest in the future than the high growth firm. As it separates different types through different interest payments, not through different bankruptcy costs, issuing a risk-compensating PSD is an inexpensive way for the high growth type firm to signal its type.

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