Monetary Surprises, Debt Structure and Credit Misallocation

Abstract

How does firm dynamically adjust its capital and debt structure in response to interest rate risk? Using micro-data, I find that bond spread increases more than loan spread and firms rebalance towards bank loans and away from corporate bonds in response to unexpected monetary tightening. I explain this pattern in a heterogeneous agents New Keynesian model by making bank loans safer (collateralized) than market debt but issued at a greater intermediation cost. Large firms with ample debt capacity are relatively better at bearing this cost and the substitution takes place following an unanticipated rate hikes, while small constrained firms tend to issue more equity. This causes credit to be reallocated from constrained productive to unconstrained firms, exacerbating the economy’s capital misallocation. Additionally, debt structure affects firm's investment sensitivity to interest rate risk: firms with higher loan share reduce investment more aggressively when interest rate rises.