A rating trigger is a particular type of debt covenant that mandates the borrower to maintain its own credit rating above a certain rating threshold, requiring, in the event of a rating downgrade, the adoption of specific enforceable actions aimed at securing the lender claims from the borrower's higher risk level. Rating triggers lower the cost of borrowing capital, but when activated, they exacerbate the borrower's need for liquidity just at the moment when its credit risk is higher, making the borrower's default more likely to occur. Despite the potential threat posed by rating triggers on debt markets, these contractual devices remain almost unregulated both in the US and in Europe. The purpose of this paper is first to analyse the effects rating triggers can have on overall market risk and second to assess the proliferation of rating triggers among large US and non-US companies in order to establish whether these contractual devices need stricter regulation. The article is divided in two parts. Sections 2 to 5 provide an overview of the different types of triggers and analyse the rationale behind their use in terms of advantages and disadvantages for both issuers and investors. In sections 6 to 9, I perform an empirical analysis by assessing the rating triggers that have been used by Dow Jones Industrial Average Index companies. I then examine the correlation between the use of rating triggers and the companies' risk profiles by measuring their credit ratings and their Altman's Z-Scores in order to find out whether triggers are mostly used by risky companies, capable of being impaired by the triggers' activation and thus posing a threat to market stability. In section 10, I strengthen the analysis by examining whether such correlation also applies to non-US companies which use rating triggers. In section 11 conclusions are drawn suggesting the introduction by US and European regulators of a specific duty to disclose all the rating triggers that listed companies include in bond indentures and in financial contracts every year.

We model the evolution of the credit migration of a corporate bond as an inhomogeneous semi-Markov chain. The valuation of a defaultable bond is done with the use of the forward probability of no default up to maturity time. It is proved that, under the forward probability measure, the semi-Markov property is maintained. We find the functional relationships between the forward transition probability sequences and the real-world probability sequences. The stochastic monotonicity properties of the inhomogeneous semi-Markov model, which play a prominent role in these issues, are studied in detail. Finally, we study the term structure of credit spread, provide an algorithm for the estimation of the forward probabilities of transitions under the risk premium assumptions, and present an estimation method for the real-world probability sequences.