Performance pricing in bank debt contracts

Performance pricing links bank debt interest rate spreads to a borrower's performance via two options. Interest-decreasing performance pricing reduces spreads if credit quality improves. It is more common when prepayment is more likely or costly and when adverse selection costs are higher, and is less common when multiple performance measures better predict credit quality. Interest- increasing performance pricing increases spreads if credit quality deteriorates. It is more common when lenders reduce interest rates to add this provision, when downgrades are more likely, and when moral hazard costs are higher. We find lower spreads for contracts with interest increasing performance pricing. (c) 2005 Elsevier B.V. All rights reserved.