Debt structure
Debt structure
21-Nov-2022
11 Debt structure
Debt characteristics
Debt types
Debt specialization
Conclusion
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Debt structure
References
Mandatory:
Colla et al. (2020)
Hackbarth and Mauer (2012) → in a later lecture
Voluntary:
Hillier et al. (2012, Ch. 2)
Roberts and Sufi (2009)
Chava et al. (2019)
Background:
Colla et al. (2013)
Rauh and Sufi (2010)
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Debt structure
1. Introduction
(Colla et al., 2020)
Debt characteristics
maturity
priority
Debt types
bank loans
corporate bonds
credit lines
commercial paper
capital leases
Debt specialization
Directions for future research
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Debt structure Debt characteristics
Debt structure
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Debt characteristics
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Debt structure Debt characteristics
2. Debt characteristics
(Colla et al., 2020)
2.1 Maturity
2.2 Priority
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Debt structure Debt characteristics
2.1 Maturity
(Colla et al., 2020)
Main factors for choice of debt maturity:
1 agency costs
2 asymmetric information
3 taxes
4 maturity of a firm’s assets
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Debt structure Debt characteristics
Maturity – 1. Agency costs
Shorten debt maturity to mitigate the underinvestment motive
because debt matures before an investment opportunity
materializes (Myers, 1977).
→ see next lecture
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Debt structure Debt characteristics
Maturity – 2. Asymmetric information
Flannery (1986):
Borrowers with favorable private information issue short-term debt
and roll it over – refinancing rates cheaper in future, when
information resolves.
Bad-quality borrowers instead resort to long-term debt to avoid the
costs associated with debt rollover
Diamond (1991): incorporates liquidation/liquidity risk.
→ Borrowers choose maturity dependent on their credit quality
high credit quality: borrow short term – information effect
outweighs liquidity risk
medium credit quality: issue long-term debt to avoid liquidation.
low credit quality: would also like to borrow long term. However,
lenders unwilling to provide long-term funding to these firms, which
will then issue short-term debt and bear liquidation risk.
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Debt structure Debt characteristics
Maturity – 3. Taxes
Lengthening (shortening) debt maturity reduces a firm’s expected
tax liability, thereby increasing firm value, when term structure of
interest rates upward (downward) sloping (Brick and Ravid, 1985).
Kane et al. (1985): predict that debt maturity inversely related to
firm’s effective tax rate and asset volatility.
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Debt structure Debt characteristics
Maturity – 4. Maturity of a firm’s assets
Maturity-matching principle:
firm should match maturity of liabilities to that of its assets.
Note: most popular in banking
– maturity of real assets more tricky
Morris (1976): maturity matching reduces both
risk that cash flows from assets will be insufficient to repay principal
when debt matures before assets do and
risk of firms not being able to service future debt payments when
assets have ceased to yield income.
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Debt structure Debt characteristics
Maturity – Recent (2000+) evidence
Billett et al. (2007):
Examine joint determinants of leverage, maturity, and covenant
protection.
Findings: covenant protection increasing in leverage and
market-to-book ratio, and decreasing in short-term proportion of
firm’s debt
Consistent with notion that firms use covenants to control
shareholder-bondholder conflicts over exercise of growth options
(→ Myers, 1977, underinvestment motive)
– debt maturity and covenants substitutes in controlling these
conflicts.
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Debt structure Debt characteristics
Maturity – Recent (2000+) evidence
Custódio et al. (2013a):
asymmetric information constitutes an important driver of debt
maturity
Firms rely more on short-term debt if
More (R&D)–intensive
More volatile assets
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Debt structure Debt characteristics
Maturity – Recent (2000+) evidence
Choi et al. (2018):
Focus on decision to spread out (or concentrate) maturity dates
across time.
Fixed costs involved in multiple issues make maturity dispersion
expensive
Uncertainty about credit–supply conditions at refinancing date
renders maturity concentration costly
Empirical strategy: Making use of exogenous shock to bond
rollover risk (e.g., GM and Ford downgrade in May 2005)
Findings: firms that have more maturing debt to roll over
immediately after shock increase dispersion of maturity profile
more than a control group of otherwise similar firms.
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Debt structure Debt characteristics
2.2 Priority
(Colla et al., 2020)
Corporate debt structure typically includes claims that differ in
their liquidation priority in the case of default.
Such priority can be established by
granting rights to collateral (security) and/or
by including antidilutive provisions that prioritize payments
(e.g., negative pledge covenants).
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Debt structure Debt characteristics
Priority – theory
Stulz and Johnson (1985):
issuing secured debt, by limiting claims of existing debt holders in
new projects, can alleviate underinvestment problem.
→ firms with more acute conflicts between debt holders and
shareholders should rely more on secured debt.
Besanko and Thakor (1987): asymmetric information model,
collateral serves as a signaling/screening device
Higher-quality borrowers issue secured debt with lower interest rate
Lower-quality projects financed by unsecured debt with higher
interest rate.
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Debt structure Debt characteristics
Priority – theory
Hackbarth and Mauer (2012):
Interaction between financing and investment decisions in dynamic
model
Firm has multiple debt issues and equityholders choose timing of
investment
Debt priority serves as a dynamically optimal contract
→ jointly optimal capital and priority structures can virtually
eliminate investment distortions
→ covered in more detail later in lecture
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Debt structure Debt characteristics
Priority – theory
Donaldson et al. (2020):
model in which secured debt, by encumbering assets, can limit
borrower’s flexibility and thus worsen, rather than ameliorate,
underinvestment problem.
(6= Stulz and Johnson, 1985, above)
optimal debt structure:
mix of secured debt, unsecured senior debt, and unsecured debt
without negative pledge covenants (junior debt).
allows borrowers to limit underinvestment problem associated with
secured debt and risk of dilution associated with unsecured debt.
priority dispersion shown to be more prominent when firms
approach distress.
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Debt structure Debt characteristics
Priority – evidence
Barclay and Smith Jr (1995):
sort debt claims in descending order of priority:
capital leases
secured debt
ordinary debt
subordinated debt
Capital leases shown to be positively associated with the
market-to-book ratio, consistent with agency costs considerations.
Abnormal future earnings (a proxy for a firm’s unobserved quality)
not significantly associated with corporate priority structure,
providing little support for the signaling hypothesis.
heterogeneity across firms in their debt priority structure: Small
firms and firms with greater growth opportunities make use of
fewer priority claims.
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Debt structure Debt characteristics
Priority – evidence
Rauh and Sufi (2010):
stratify corporate debt into
secured debt
senior unsecured debt
subordinated debt
investigate relation between firm’s credit quality (issuer rating) and
debt priority
Findings:
firms with better credit quality rely almost exclusively on senior
unsecured debt
while firms with lower credit quality spread their priority structure by
issuing both secured and subordinated debt
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Debt structure Debt characteristics
Priority – evidence
Badoer et al. (2020):
investigate relation between financial distress and debt priority
structure.
Findings: as asset volatility increases (i.e., distance to default
decreases), firms rely more on secured and subordinated debt
and less on senior debt.
interpreted as consistent with work by Donaldson et al. (2019)
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Debt structure
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Debt types
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Debt structure Debt types
3. Debt types
(Colla et al., 2020)
3.1 Bank loans & corporate bonds
3.2 Credit lines
3.3 Commercial paper
3.4 Capital leases
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Debt structure
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Debt specialization
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Debt structure Debt specialization
4. Debt structure of public U.S. firms
Rauh and Sufi (2010):
examine financial footnotes contained in 10-K filings
data set for 305 rated public U.S. firms over period 1996–2006
classify debt into seven broad categories:
bank debt, bonds, program debt, private placements,
mortgage/equipment debt, convertible, and other debt
Colla et al. (2013):
Use Capital IQ database
public U.S. firms’ debt structure over period 2002–2009
3,296 public US firms – both rated and unrated
Colla et al. (2020) update their earlier work to period 2002–2018,
more than 4,500 firms
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Debt structure Debt specialization
4.1. Measures of Debt Specialization
Capital IQ:
decomposes total debt into seven mutually exclusive debt types
1 commercial paper (CP)
2 drawn credit lines (DC)
3 term loans (TL)
4 senior bonds and notes (SBN)
5 subordinated bonds and notes (SUB)
6 capital leases (CL)
7 other debt (Other)
Two measures of debt structure (Colla et al., 2013)
1 Herfindahl-Hirschman Index (HHI) of debt type usage
exclusively one single debt type: HHI = 1
all seven debt types in equal proportions: HHI = 0
2 Indicator variable, Excl90i,t = 1 if firm obtains at least 90% of debt
from one debt type, 0 otherwise
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Sample distribution of debt types and specialization
(Colla et al., 2020, Table 1)
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Cluster analysis
(Colla et al., 2020, Table 3)
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Debt structure Debt specialization
Reliance on one debt type
(Colla et al., 2020, Table 4)
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Debt structure Debt specialization
4.4. Why Do Firms Specialize?
Colla et al. (2013) propose three possible explanations for debt
specialization:
1 reducing expected bankruptcy costs
2 economizing on information collection and monitoring costs
3 lacking access to some segments of the debt markets
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Debt structure Debt specialization
Explaining debt specialization
(Colla et al., 2020, Table 6)
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Debt structure Conclusion
Debt structure
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Conclusion
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Debt structure Conclusion
Conclusion – Colla et al. (2020)
theoretical justifications for choice of specific debt characteristic or
debt type
summarized empirical evidence on usage of different debt
instruments
updated evidence on debt specialization:
pattern uncovered in Colla et al. (2013) remains applicable:
More than three-quarters of public US firms concentrate their
borrowing in one debt instrument.
offered some suggestive explanations for observed pattern.
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