Executive Compensation and the Maturity Structure of Corporate Debt

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, December 28, 2009
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This post comes to us from Paul Brockman, Professor of Finance at Lehigh University, Xiumin Martin, Assistant Professor of Accounting at Washington University, and Emre Unlu, Assistant Professor of Finance at the University of Nebraska.

In our paper, Executive Compensation and the Maturity Structure of Corporate Debt, which was recently accepted for publication in the Journal of Finance, we investigate the role of short-term debt in reducing agency costs of debt arising from executive incentive contracts. Specifically, we examine the effect of the two portfolio sensitivities on the maturity structure of corporate debt. In addition, we analyze the effect of debt maturity on the relation between portfolio sensitivities and bond yields.

We study the causal link between CEO incentive compensation and corporate debt maturity using a sample of 6,825 firm-year observations during the 14-year period from 1992 to 2005. We employ alternative definitions of short-term debt, follow Core and Guay’s (2002) method for estimating option sensitivities, and then apply several empirical methodologies (e.g., pooled OLS and GMM simultaneous equation estimation, fixed-effect regressions, change-invariables regressions) and an alternative new debt issuance sample to analyze the predicted relations.

We find a negative and significant relation between CEO portfolio deltas and short-term debt. We also find a positive and significant relation between CEO portfolio vegas and short-term debt. Taken together, these findings suggest that short-term debt is used to reduce agency costs associated with high managerial compensation risk. Our empirical results are robust to controlling for CEO stock ownership, leverage, asset maturity, growth opportunities, firm size, term structure, bond rating, and other issuer characteristics.

Next, we use a sample of 268,400 bond-day observations for 114 unique firms during the period from 1994 to 2005 to examine whether short-maturity debt mitigates the impact of managerial incentives on the cost of debt. We find that higher deltas (vegas) lead to lower (higher) borrowing costs. More importantly, we show that short-term debt attenuates the negative (positive) relation between bond yields and deltas (vegas).

The full paper is available for download here.

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