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A Collateral Theory of Endogenous Debt Maturity

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  • R. Matthew Darst
  • Ehraz Refayet

Abstract

This paper studies optimal debt maturity when firms must use collateral to back non-contingent claims. The optimal term structure of debt trades-off long-term borrowing costs and short-term refinancing costs because the price of risk is different across states and through time. Issuing both long- and short-term debt allows firms to cater risky promises across time to investors most willing to hold risk. Collateral frictions produce a rich term structure of debt that includes safe "money-like" debt, risky short- and long-term debt, and contrast existing theories predicated on information frictions or liquidity risk. Lastly, we show that "hard" secured debt covenants in long-term debt do not affect investment or credit spreads when collateral is scarce because they act as perfect substitutes for short-term debt.

Suggested Citation

  • R. Matthew Darst & Ehraz Refayet, 2017. "A Collateral Theory of Endogenous Debt Maturity," 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.2017.057
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    File URL: https://www.federalreserve.gov/econres/feds/files/2017057pap.pdf
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    References listed on IDEAS

    as
    1. Douglas W. Diamond & Zhiguo He, 2014. "A Theory of Debt Maturity: The Long and Short of Debt Overhang," Journal of Finance, American Finance Association, vol. 69(2), pages 719-762, April.
    2. Flannery, Mark J, 1986. " Asymmetric Information and Risky Debt Maturity Choice," Journal of Finance, American Finance Association, vol. 41(1), pages 19-37, March.
    3. Hayne E. Leland, 1998. "Agency Costs, Risk Management, and Capital Structure," Journal of Finance, American Finance Association, vol. 53(4), pages 1213-1243, August.
    4. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
    5. 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.
    6. 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.
    7. 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.
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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
    • 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
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity

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