Capital Structure and Debt Structure

In the paper, Capital Structure and Debt Structure, forthcoming in the Review of Financial Studies, we use a novel data set on the debt structure of a large sample of rated public firms and show that debt heterogeneity is a first order aspect of firm capital structure. The majority of firms in our sample simultaneously use bank and non-bank debt, and we show that a unique focus on leverage ratios misses important variation in security issuance decisions. Furthermore, cross-sectional correlations between traditional determinants of capital structure (such as profitability) and different debt types are heterogeneous. These findings suggest that an understanding of corporate capital structure necessitates an understanding of how and why firms use multiple types, sources, and priorities of corporate debt.

We then examine debt structure across the credit quality distribution. We show that firms of lower credit quality have substantially more spreading in their priority structure, using a multi-tiered debt structure often consisting of both secured and subordinated debt issues. We corroborate these results in a separately collected dataset for firms that experience a drop in credit quality from investment grade to speculative grade. Here too, firms spread their priority structure as they worsen in credit quality. The spreading of the capital structure as credit quality deteriorates is therefore both a cross-sectional and within-firm phenomenon. The increased secured debt used by lower quality firms is generally secured bank debt, whereas the increased subordinated debt is in the form of bonds and convertibles

The spreading of the capital structure as credit quality deteriorates is broadly consistent with models such as Park (2000) that view the existence of priority structure as the optimal solution to manager-creditor incentive problems. However, to our knowledge, the existing models do not exactly deliver the dynamics that we find. For example, they do not derive differential priority structures as a function of a continuum of either moral hazard severity or creditor quality types. Further, these models do not explain why non-bank issues after a firm is downgraded must be subordinated to existing non-bank debt or convertible to equity. Theoretical research suggests that the use of convertibles can mitigate risk shifting by making the security’s value less sensitive to the volatility of cash flows (Brennan and Schwartz, 1988) or by overcoming the asymmetric information problem in equity issuance (Stein, 1992).

The full paper is available for download here.