Secured Debt and Corporate Performance:Evidence from REITs

Abstract

A number of competing theories have developed regarding the use of secured debt by firms. In adverse selection models, borrowers use collateral to signal quality, whilst moral hazard models assume that the use of collateral improves the incentives for borrowers to work hard to repay debt. In this paper, we empirically test these two competing theories. Specifically, we answer the following question: Does the use of secured debt result in a performance difference between firms that employ a higher proportion of secured debt versus firms that utilize unsecured debt? We find robust evidence that an increase in the use of secured debt by REITs is associated with positive excess returns in the following quarter. In addition, we observe that small REITs with high leverage are more likely to increase their secured debt ratio. Taken together, the results suggest that moral hazard models of collateral are more relevant in explaining the positive firm utilization of secured debt and future stock performance.