Economic Distress and the Maturity of Debt

Abstract

This paper explores the relationship between aggregate economic distress and the maturity of debt. I argue that lenders would prefer shorter maturity of debt during periods of economic distress. I develop two lines of argument based on debt contracting to support this prediction, and the rationales rely heavily on the role that default risk and screening plays in lending transactions. In the first line of argument, a lender chooses the debt contract tenor that maximizes her expected profits. In doing so, she weighs the role of capital rotation with the expected margin on each transaction and the probability that the borrower defaults. The probability of the borrower defaulting depends on the aggregate economic conditions. As a result, a shock that reduces economic stability leads the lender to prefer shorter maturities on new debt contracts. The second argument builds on the concept of the lender’s rollover option, which is her opportunity to relend her loanable funds after collection. During times of economic distress this option is more valuable to the lender, who increases her number of options by shortening the maturity of new contracts. Finally, I test these predictions empirically using over twenty years of U.S. bank and public debt issues to show a significant negative relationship between aggregate economic riskiness and maturity of new debt contracts. Moreover, shortening maturities result in changes in the temporal financial structure of public nonfinancial corporations.