Default Risk, Inside Debt and Debt Incentives

Abstract

We study the relation between firms' default risk and CEOs' debt incentives. Traditional principal-agent theory suggests that agency costs of debt are primary determinants of the relation. Specifically, firms with higher default risk are likely to face higher agency costs of debt and hence should provide higher debt incentives. Yet other factors affecting risk-taking, such as CEO risk aversion or career concerns, may diminish the need for firms with higher default risk to provide debt incentives. Using a difference-in-differences approach, we find evidence that does not support the agency costs of debt hypothesis, but is consistent with the risk-taking hypothesis.