Debt Maturity and the Dynamics of Leverage

Abstract

This paper shows that short debt maturities commit equityholders to leverage reductions when refinancing expiring debt in low-profitability states. However, shorter maturities lead to higher transaction costs since larger amounts of expiring debt need to be refinanced. We show that this trade-off between higher expected transaction costs against the commitment to reduce leverage in low-profitability states motivates an optimal maturity structure of corporate debt. Since firms with high costs of financial distress and risky cash flows benefit most from committing to leverage reductions, they have a stronger motive to issue short-term debt. Evidence supports the model’s predictions.

Corporate risk-taking after changes in credit rating

“…This study also documents that the increase in leverage of downgraded firms is attributed to increase in long-term debt. This finding complements the literature on the theory of optimal debt maturity for financially constrained firms, where some studies suggest short-term debt as the optimal choice for risk-taking, whilst others argue that long-term debt is the preferred option (see, for example, Leland and Toft, 1996;Danielova et al, 2013;Wang and Chiu, 2019;Gopalan et al, 2014;Dangl and Zechner, 2016;Seta et al, 2020). As such, this study contributes to the literature not only by providing empirical evidence on corporate risk-taking after a change or downgrade in CR, but also complementing to the discussions in the optimal debt-maturity choice literature.…”

“…In the previous section, downgraded firms are documented to be associated with significantly higher leverage three years after changes in CR. Dangl and Zechner (2016) argue that firms with low CR have a stronger motive to issue short-term debt because debt with short maturity commits the firms to reduce leverage should the firms go into bankruptcy. Financially distressed firms issuing short-debt maturity, however, face with high-rollover risk, which can increase their default risk (Wang and Chiu, 2019;Seta et al, 2020;Gopalan et al, 2014).…”

The role of asset payouts in the estimation of default barriers

“…Although in principle one can compute a weighted average duration of a firm's bonds, we set T = 10 years for industrial firms to make our results directly comparable to the BT model. We realize however, that the maturity of debt is a result of an optimizing process characterizing a particular firm (Nengjiu and Hui, 2006;Choi et al, 2018;Dangl and Zechner, 2021). Stohs and Mauer (1996) report that 95% of firms have a debt maturity of less than 10 years in their sample.…”

Financial Leverage and Debt Maturity Targeting: International Evidence

“…Exposed to the risk of not being able to refund, firms may prefer to lengthen the maturity of their debt to minimize bankruptcy costs arising from inefficient liquidation due to higher default and liquidity risks (Diamond 1991). On the other hand, firms suffering from high costs of financial distress, exposing their managers to the risk of losing control, benefit the most from committing to leverage reductions and thus may have greater incentive to issue short-term debt (Dangl and Zechner 2021). Higher distress costs are associated with up to 2% lower desired long-term debt in support of the conjecture that firms commit to leverage reductions when distress costs are prominent and that the choice of debt composition is an alternative mechanism for controlling financial distress costs.…”