As the storm clouds thicken in Europe's telecommunications sector and rating agencies threaten rain, coupon step-ups are increasingly used by companies aware of the necessity of providing investors with an umbrella. However not everyone trusts them.

France Telecom's $16 billion corporate bond issue in March 2001 yielded a $28 billion take-up. Investors, enticed by substantial downside protection and very generous yields compared with the rest of the telecoms bond market, appeared confident they were sheltering safely.

Francois Loizillon, manager of the consultants programme at France Telecom, explained, "The bond issue is a fair offer; if the situation does get worse, shareholders will be protected by very high interest rates."

Much of Loizillon's buoyancy stems from faith in the company's operations. He said, "I don't think there will be a huge effect on the bond market if France Telecom is downgraded by rating agencies. Anyway it's not that likely; we are more successful than many other telecoms."

If shareholder confidence can approximate that of France Telecom then, says James Duberley, portfolio manager for the Frank Russell Company, coupon step-ups are an attractive proposition. "The crux is whether the investor has confidence in the company's ability to pay ultimately," says Duberley. "There is a danger surrounding longterm deterioration but lots of European companies are a long way from that. The biggest telcos are maintaining a reasonable credit quality despite downward momentum."

Eva Ho, telecoms credit analyst with JP Morgan Fleming Asset Management, is wary however. "For an investor without protection the coupon step-up isn't commensurate with the risk. It's better than nothing but it wouldn't fully compensate if the downgrade was significant," she says.

Investors should also ensure their coupon step-ups are triggered per single agency downgrade, warns Ho, as rating agencies may not reduce their ratings at the same speed. She cites Deutsche Telekom's June 2000 bond issue, saying, "The step-up was only valid if both rating agencies downgraded the company credit below the single A area."

The alternatives to coupon step-ups are few. Some companies offer covenants to investors which restrict corporate decision-making but, given the tight rein financially of most telcos, both the company and its investors would be in a quandry if the covenant is broken. BT's recent 'put' option promised investors reimbursement if a ratings freefall was triggered by company restructuring. Analysts calculated that if BT's ratings fell to the triple-B category, its interest bill would swell by around £150-200m per year.

BT has in some respects broken the mould by announcing recently it would rather preserve shareholder value and sacrifice its credit rating than sell its assets below their true value. Ho approves of this approach, asserting that the integrity of a company's operational plan increases its value in the market. CEOs, she feels, should not be guided by the rating level - the operational plan should be a personal decision so the company operates on a level with which it is comfortable. "There are plenty of triple B-rated telecoms operating in the States and doing fine," says Ho.

Some critics suggest restricting the use of coupon step-ups so they only compensate investors when their chosen telco's rating has fallen below the levels of its counterparts. They argue that an investor opting for a high risk sector should claim responsibility for doing so. Not everyone agrees. "Investment is company-specific," one analyst objected, "company bonds cannot be tied to the industry as a whole." Eva Ho at JP Morgan is also adamant, claiming that companies cannot be viewed as equals. BT shouldn't have the same rating as either France Telecom or Deutsche Telekom, she believes.