Abstract
We introduce long-term debt and a maturity choice into a dynamic model of production, firm financing, and costly default. Long-term debt saves roll-over costs but increases future leverage and default rates because of a commitment problem. The model generates rich distributions of maturity choices, leverage ratios, and credit spreads across firms. It explains why larger and older firms borrow at longer maturities, have higher leverage, and pay lower credit spreads. Firms' maturity choice matters for policy: A financial reform which increases investment and output in a standard model of short-term debt can have the opposite effect in a model with short-term debt and long-term debt.
Highlights
Borrowing costs for U.S firms increased dramatically during the Great Recession
The default rate on corporate bonds increased from 0.13% in 2007 to 2.48% in 2009.1 What drives these fluctuations in credit spreads and default rates? The standard approach in the literature is to address this question using a model of one-period debt
Within a fully dynamic economy, we show that cyclical debt dilution generates the observed counter-cyclical behavior of default, bond spreads, leverage, and debt maturity
Summary
Borrowing costs for U.S firms increased dramatically during the Great Recession. The default rate on corporate bonds increased from 0.13% in 2007 to 2.48% in 2009.1 What drives these fluctuations in credit spreads and default rates? The standard approach in the literature is to address this question using a model of one-period debt. In the first part of the paper, we use a simple two-period model to derive analytical results on the cyclical role of debt dilution in driving credit spreads and default rates. We use these analytical results to interpret the numerical findings of our fully dynamic model economy. We consider two policy experiments which both eliminate debt dilution: (1.) a ban of long-term debt, and (2.) a debt covenant which helps firms to internalize the cost of debt dilution Both policies improve welfare by reducing credit spreads and increasing investment.
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