Capital Structure and the Yield Curve

Abstract

Abstract We develop a dynamic capital structure model in which interest rates are stochastic and driven by three state variables: level, slope, and curvature of the yield curve in an arbitrage-free Nelson-Siegel model. Our analysis suggests that the yield-curve factors are critical determinants of the capital structure of firms and that an increase in any of the three factors is followed by an increase of the firm’s leverage and a shortening of its debt maturity. We perform a two-stage least squares system of equations that accounts for the joint determination of leverage and debt maturity and confirms our model’s predictions. (JEL E43, G12, G32) Received February 16, 2022; editorial decision: August 13, 2022 by Editor Robert Marquez. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.