Capital Structure, Credit Risk, and Macroeconomic Conditions

Abstract

This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity. r

The Same Bond at Different Prices: Identifying Search Frictions and Selling Pressures

“…Jones, Mason, and Rosenfeld (1984) and more recently Huang and Huang (2003) HH03 also show that proposed extensions of the Merton model such as jumps in firm value, stochastic interest rates, endogenously determined default boundary, and meanreverting leverage ratios do not come close to solving the puzzle once they are calibrated with empirically reasonable parameters. More recent papers such as Hackbarth, Miao, and Morellec (2006), Chen, Collin-Dufresne, and Goldstein (2009), Chen (2009), and Bhamra, Kuehn, and Strebulaev (2009 link firm decisions, earnings, risk premia, and/or default rates to the business cycle. They show that realistic credit spreads are generated at longer maturities and for firms with a rating of typically BBB.…”

Financing and takeovers

“…The lower leveraged bidder still is able to offer a higher takeover premium, and the results are qualitatively similar to the static case. For dynamic capital structure strategies in a single firm framework, see, for example, Fischer, Heinkel, and Zechner (1989), Goldstein, Ju, and Leland (2001), Strebulaev (2007), or Hackbarth, Miao, and Morellec (2006). Fig.…”

Credit Risk and Business Cycles

“…All corporate bonds have finite maturity. To stay in a stationary environment, we adapt the continuous time model of Leland (1998) and Hackbarth, Miao and Morellec (2006) to our discrete time framework. Specifically, we assume that with probability λ, bonds retire and each unit of outstanding bonds promises to pay one unit of the consumption good in the next period.…”

“…Computing a dynamic general equilibrium model is even more difficult because one has to track the whole history of non-matured debts as new debt is issued each period. To deal with this difficulty, we adapt the continuous-time modelling of Leland (1998) and Hackbarth, Miao and Morellec (2006) to our discrete-time framework. 1 Specifically, we assume that each period each unit of bonds retires with some positive probability, and with the remaining probability this unit does not retire and pays out a coupon rate.…”

“…Our modelling of corporate bonds is related to the corporate finance literature on the pricing of corporate securities (see, e.g., Merton (1974), Leland (1994Leland ( , 1998, Golstein, Ju, and Leland (2001), Hackbarth, Miao and Morellec (2006), Chen, Collin-Dufresne and Goldstein (2009), Bhamra, Kuhn and Strebulaev (2008), and Chen (2010). This literature typically considers a pure exchange economy or simply assumes exogenous pricing kernel and takes a firm's cash flows as exogenously given.…”