Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads

Abstract

We build a structural model to explain corporate debt maturity dynamics over the business cycle and their implications for the term structure of credit spreads. Longer-term debt helps lower firms' default risks while shorter-term debt reduces investors' exposures to liquidity shocks. The joint variations in default risks and liquidity frictions over the business cycle cause debt maturity to lengthen in economic expansions and shorten in recessions. The model predicts that firms with higher systematic risk exposures will choose longer debt maturity, and that this cross-sectional relation between systematic risk and debt maturity will be stronger when risk premium is high. It also shows that the pro-cyclical maturity dynamics induced by liquidity frictions can signi cantly amplify the impact of aggregate shocks on credit risk, with different effects across the term structure, and that maturity management is especially important in helping high-beta and high-leverage firms reduce the impact of a crisis event that shuts down long-term refinancing. Finally, we provide empirical evidence for the model predictions on both debt maturity and credit spreads.