Coupon step up
Capital MarketsA clause raising a bond's coupon if the issuer is downgraded past a stated threshold, and lowering it again on an upgrade.
Also written: ratings based step up, step up provision
A ratings based step up raises the coupon by a fixed increment for each notch of downgrade past a specified trigger, usually with a cap on the total increase, and steps back down if the rating recovers. The linkage is intended to be symmetric rather than a one way penalty.
It is not a put. The investor does not get their money back on a downgrade, they are paid more for continuing to hold a bond that has become riskier. That is a genuinely different protection from a change of control put, and confusing the two is a common error.
The structure clusters in sectors that lever up periodically for visible reasons, such as telecoms funding spectrum purchases and network build, or utilities funding large capital programmes. Those issuers can see a leveraging event coming and would rather price the risk into the terms up front than argue about it with investors afterwards.
The trade for the issuer is worth stating plainly: it buys a tighter spread at issue and accepts a contingent increase in interest expense that arrives exactly when the business is under strain and can least afford it.
Worked example
A telecom issues ten year notes with a step up triggered if either agency moves it below investment grade, at a fixed increment a notch and capped at a stated maximum.
Investors accept a tighter initial spread because the downside is compensated automatically. If the company then buys spectrum with debt and is downgraded two notches, its interest bill rises in the same year its leverage does.