The pricing of risky coupon bonds

It is shown that bond valuation without due consideration to debt-servicing arrangements can lead to a misspecification of default risks and hence in the credit rating attached to the bond. The general conclusion is that default probabilities depend not only upon a firm's leverage and the volatitily of its underlying asset returns but also on how its debt is funded. Unfortunately, there is no one single exposition in the literature which deals with this problem. The paper compares, in a systematic way, the structure of alternative debt-servicing arrangements and sinking fund provisions, first from a theoretical perspective and then through the use of numerical simulations. The existing theoretical literature takes one of two approaches: first, where the funding of coupons takes place through the issue of new equity, and second, where the coupons are funded through deductions from the assets of the issuer. Both involve different stochastic processes and valuation procedures. These two cases are each examined under two different scenarios: (i) payment of the coupon at each servicing date with face value repaid at maturity; and (ii) a sinking fund involving mandatory redemption where firms retire a proportion of the debt each period at face value in addition to making coupon payments on the outstanding debt. Each of these four scenarios has different implications for default risk.