Debt Maturity Structure and Liquidity Risk

Abstract

This paper analyzes debt maturity structure for borrowers with private information about their future credit rating. Borrowers' projects provide them with rents that they cannot assign to lenders. The optimal maturity structure trades off a preference for short maturity due to expecting their credit rating to improve, against liquidity risk. Liquidity risk is the risk that a borrower will lose the nonassignable rents due to excessive liquidation incentives of lenders. Borrowers with high credit ratings prefer short-term debt, and those with somewhat lower ratings prefer long-term debt. Still lower rated borrowers can issue only short-term debt. I. INTRODUCTION AND OVERVIEW This paper analyzes the choice of debt maturity by firms. Short-term debt matures before the cash flows arrive from a firm's investments and must be refinanced at terms that depend on its future credit rating. Long-term debt, in contrast, has maturity matching the timing of the cash flows. Maturity is thus measured relative to the timing of arrival of cash flows, rather than in calendar time. In this paper I ask how borrowers choose maturity structure and how their choice depends on their credit rating. As a stylized fact, firms with high credit ratings issue short-term debt (commercial paper) directly to investors. Firms with lower credit ratings issue long-term bonds or borrow through financial intermediaries such as banks. The lower rated borrowers' bank loans are of relatively short term. Borrowers who rely heavily on short-term debt are then a mix of the very high and low rated borrowers, with the middle rated borrowers using more long-term debt. This paper develops a model that explains this behavior. Debt maturity choice is analyzed as a trade-off between a borrower's preference for short-term debt due to private information about the future credit rating, and liquidity risk. Liquidity risk from short-term debt arises from the borrower's loss of control rents in the event that lenders are unwilling to refinance when bad *1 am grateful for financial support from the Garn Institute of Finance, National Science Foundation grant number SES-8896223, and from Dimensional Fund Advisors, and for helpful comments from Robert Gertner, Andrei Shleifer, Robert Vishny, an anonymous referee, and workshop participants at the

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