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A Model of Endogenous Debt Maturity with Heterogeneous Beliefs

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  • R. Matthew Darst
  • Ehraz Refayet

Abstract

This paper studies optimal debt maturity in an economy with repayment enforcement frictions and investors disagree about repayment probabilities. The optimal debt maturity choice is a mix of long- and short-term debt securities. Spreading risky debt claims on cash flows over time allows debt to be priced by investors most willing to hold risk at each point in time, thereby increasing investment and output. By contrast, a single maturity, either all long- or short-term, will be priced by investors less willing to hold risk, which reduces investment and output. The model provides a novel explanation for the stylized fact that large and mature companies almost always issue debt with multiple maturities rather than a single maturity, and is broadly consistent with empirical debt maturity results. Lastly, we show that non-financial covenants that prevent debt dilution only serve as substitutes for short-term debt and do not affect real outcomes as they do not allow the firm to create additional collateral against which to borrow.

Suggested Citation

  • R. Matthew Darst & Ehraz Refayet, 2017. "A Model of Endogenous Debt Maturity with Heterogeneous Beliefs," Finance and Economics Discussion Series 2017-057, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2017-57
    DOI: 10.17016/FEDS.2017.057r1
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    References listed on IDEAS

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    1. Hui Chen & Yu Xu & Jun Yang, 2012. "Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads," NBER Working Papers 18367, National Bureau of Economic Research, Inc.
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    7. Shane A. Johnson, 2003. "Debt Maturity and the Effects of Growth Opportunities and Liquidity Risk on Leverage," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 209-236.
    8. Nishant Dass & Massimo Massa, 2014. "The Variety of Maturities Offered by Firms and Institutional Investment in Corporate Bonds," Review of Financial Studies, Society for Financial Studies, vol. 27(7), pages 2219-2266.
    9. Matthias Kahl & Anil Shivdasani & Yihui Wang, 2015. "Short-Term Debt as Bridge Financing: Evidence from the Commercial Paper Market," Journal of Finance, American Finance Association, vol. 70(1), pages 211-255, February.
    10. R. Matthew Darst & Ehraz Refayet, 2016. "Credit Default Swaps in General Equilibrium: Spillovers, Credit Spreads, and Endogenous Default," Finance and Economics Discussion Series 2016-042, Board of Governors of the Federal Reserve System (U.S.).
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    Cited by:

    1. Ṣebnem Kalemli-Özcan & Luc Laeven & David Moreno, 2018. "Debt Overhang, Rollover Risk, and Corporate Investment: Evidence from the European Crisis," NBER Working Papers 24555, National Bureau of Economic Research, Inc.
    2. Kalemli-Ozcan, Sebnem, 2018. "Debt Overhang, Rollover Risk, and Corporate Investment: Evidence from the European Crisis," CEPR Discussion Papers 13336, C.E.P.R. Discussion Papers.
    3. Caglio, Cecilia & Darst, R. Matthew & Parolin, Eric, 2019. "Half-full or half-empty? Financial institutions, CDS use, and corporate credit risk," Journal of Financial Intermediation, Elsevier, vol. 40(C).

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    More about this item

    Keywords

    Collateral; Cost of capital; Debt covenants; Debt maturity; Investment;

    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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