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FINANCIAL SERVICES REVIEW, 3(2): 143-1.56 ISSN: 1057-0810

Copyright 0 1994 by JAI Press Inc. All rights of reproduction in any form reserved.

Coupon Resets Versus Poison Puts: The Valuation of Event Risk Provisions in Corporate Debt

Joseph A. Fields David S. Kidwell Linda S. Klein

This paper examines the valuation of the two major types of event risk indenture provisions, poison puts and coupon resets, on the debt of industrial companies. In contrast with earlier work by Crabbe (1991), wefind thatprotectionprovided by poison put type of covenants is not valued by investors. The inclusion of coupon reset provisions, however, lowers the yield spread of new issued industrial bonds by 32 basis points. The yields on bonds with low credit quality ratings are reduced by including coupon reset provisions in the bond indentures.

I.

INTRODUCTION

During the 1980’s event risk became a topic of concern among bondholders, analysts, and investment bankers. Event risk refers to management actions or other events that increase the firms’ leverage or otherwise increase the risk of a company. The record number of takeovers and corporate restructurings produced numerous instances of substantial capital losses for bondholders. Event risk has continued to be headline news in the 1990’s, as evidenced by Marriott’s plan to restructure into two companies, one burdened with almost all of the existing debt. As a result, Moody’s downgraded Marriott’s bonds to junk, and the price of the bond plunged from $1100 to $800 (Mitchell, 1992). In order to protect themselves from potential capital losses due to event risk, bondholders sought protective covenants that would limit the financial effect of restructurings and other adverse managerial actions. Metropolitan Life Insurance Company, for example, declared that it would no longer purchase debt instruments without covenants that would protect it against event risk (Winkler & Herman, 1988). A recent article by Crabbe (1991)...