Arms-Length Bond Markets and Capital Structure of Firms

Abstract

Prior literature has explored the impact of the type of financial system, (bank versus stock market based), on the capital structure of firms. In this study, we examine the influence of the structure of the debt market, (arms-length versus relationship-based), on the capital structure, (debt maturity choices), of firms in a cross-country approach involving 36 countries. We assess the importance of the bond market in a given economy by examining cross-country differences in leverage and debt maturity ratios. We also examine the effect of legal systems on this relationship between the bond market and the firm’s capital (debt maturity) structure. Our results show a negative association between firm total leverage and bond market capitalization. However, the association turns positive in the case of long-term leverage. In the case of short-term debt, the banking system is found to have a significant and positive impact. We also find a significant impact of legal tradition on the association between bond markets and leverage. In general, the relation is positive in common law countries and negative in civil law countries for long-term debt. Firm size appears to be an important factor which determines the direction of association between bond markets and firm leverage. Irrespective of the legal tradition, the impact of bond markets is positive for large firms and negative for small firms.Furthermore, we find significant impact of bond markets on the debt maturity structure of firms as well. Supporting evidence is also found for the growth hypothesis: growth options are observed to bear a negative association with long-term leverage and debt maturity ratios only in those countries where bond markets are well developed.