Debt Maturity and the dynamics of leverage

Dept. of Finance, University of Vienna
12/2007; DOI: 10.2139/ssrn.890228

ABSTRACT This paper shows that long debt maturities destroy equityholders' incentives to re-duce leverage in response to poor firm performance. By contrast, a sufficiently short debt maturity commits equityholders to implement such leverage reductions. However, a short debt maturity also generates transactions costs associated with rolling over matur-ing bonds. We show that this tradeoff between higher expected transactions costs against the commitment to reduce leverage when the firm is doing poorly motivates an optimal maturity-structure of corporate debt. Since firms with high costs of financial distress benefit most from committing to leverage reductions, they have a stronger incentive to issue short-term debt. The debt maturity required to commit to future leverage reductions decreases with the volatility of the firm's cash flows. We also find that the equityholders' incentives to reduce debt is non-monotonic in the firm's leverage. If the firm is pushed towards bankruptcy by a persistent series of low cash flows, then equityholders resume issuing debt to refinance maturing bonds, even when debt maturities are short.daresan participants of the seminars at London Business School, Norwegian School of Economics and Business Administration, participants of the 2005 European Finance Association Meeting in Zürich, 2004 Annual Sum-mer UBC Finance Conference, 2004 Annual Meeting of the German Finance Association in Tübingen for their suggestions and comments.

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    ABSTRACT: We examine the role of deteriorating market liquidity in exacerbating debt crises. We extend Leland's structural credit risk model with two realistic fea-tures: illiquid secondary bond markets and a mix of short-term and long-term bonds in a …rm's debt structure. As deteriorating market liquidity pushes down bond prices, it ampli…es the conict of interest between the debt and equity holders because, to avoid bankruptcy, the equity holders have to absorb all of the short-fall from rolling over maturing bonds at the reduced market values. As a result, the equity holders choose to default at a higher fundamental threshold even if there is no friction for …rms to raise more equity. A greater fraction of short-term debt further exacerbates the debt crisis by forcing the equity holders to realize the rollover loss at a higher frequency. Our model illustrates the …nancial instability brought by overnight repos, an extreme form of short-term …nancing, to many …nancial …rms, and provides a new explanation to the widely observed ight-to-quality phenomenon. We also examine a tradeo¤ between short-term debt's cheaper …nancing cost and higher future bankruptcy cost in determining …rms'optimal debt maturity structure and liquidity management strategy.
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    ABSTRACT: Our model shows that deterioration of debt market liquidity not only leads to an increase in liquidity premium of corporate bonds but also credit risk. The latter effect originates from firms' debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt, equity holders bear the losses while maturing debt holders get paid in full. This conflict leads the firm to default at a higher fundamental threshold. Our model demonstrates an intricate interaction between liquidity premium and default premium and highlights the role of short-term debt in exacerbating rollover risk.
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    ABSTRACT: We use a compound option-based structural credit risk model to infer a term structure of banking crisis risk from market data on bank stocks in daily frequency. Considering debt service payments with different maturities this term structure assigns a separate estimator for short- and long-term default risk to each maturity. Applying the Duan (1994) maximum likelihood approach, we find for Kazakhstan that the overall crisis probability was mainly driven by short-term risk, which increased from 25% in March 2007 to 80% in December 2008. Concurrently, the long-term default risk increased from 20% to only 25% during the same period.

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