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What Do Credit Markets Tell Us About the Speed of Leverage Adjustment?

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  • Redouane Elkamhi

    (Rotman School of Management, University of Toronto, Toronto, Ontario M5S 3E6, Canada)

  • Raunaq S. Pungaliya

    (Graduate School of Business, Sungkyunkwan University, Seoul 110-745, Korea)

  • Anand M. Vijh

    (Tippie College of Business, University of Iowa, Iowa City, Iowa 52242)

Abstract

This paper proposes a new methodology to infer investors' expectations about the speed of leverage adjustment implicit in the prices of credit instruments. On average, the credit markets imply a fairly rapid annual speed of adjustment of 26% toward a firm's predicted leverage. The speed varies considerably across partitions formed by the differential implications of the pecking order, market timing, and trade-off theories of capital structure. This finding suggests that investors' expectations are formed in accordance with all three theories. We also show that the addition of firm fixed effects in the predicted leverage model gives noisier estimates of investors' expectations of future leverage, and that a firm's initial leverage is a poor estimate of its future leverage.Data, as supplemental material, are available at http://dx.doi.org/10.1287/mnsc.2013.1871 . This paper was accepted by Jerome Detemple, finance .

Suggested Citation

  • Redouane Elkamhi & Raunaq S. Pungaliya & Anand M. Vijh, 2014. "What Do Credit Markets Tell Us About the Speed of Leverage Adjustment?," Management Science, INFORMS, vol. 60(9), pages 2269-2290, September.
    • Handle: RePEc:inm:ormnsc:v:60:y:2014:i:9:p:2269-2290
    DOI: 10.1287/mnsc.2013.1871
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