Abstract
Models based on asymmetric information predict that debt is least sensitive to private information and fail to explain the illiquidity of corporate debt in secondary markets. We analyze security design with moral hazard and offer a new explanation. First, the optimal compensation contract creates incentives for the manager to engage in risk-shifting, making her interests congruent with those of shareholders. Second, because debtholders are negatively affected by risky investments, they have an incentive to acquire information and discipline the manager. Debtholders' information acquisition solves the moral hazard problem, but makes debt less liquid than equity. Debt illiquidity is correlated with credit risk.
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