Volatility and the Priority Structure of Corporate Debt

Abstract

This paper examines how exogenous shocks to volatility affect the priority structure of corporate debt. We argue that increases in volatility reduce corporate debt capacity and increase the potential for dilution of existing debt holders. We hypothesize that as the potential for dilution increases, debt holders will attempt to mitigate dilution by establishing priority through collateral grants rather than through negative pledge covenants. More important, we hypothesize that increases in volatility increase the cost of senior debt relative to secured and subordinated debt which results in priority spreading; with firms increasing their reliance on both secured and subordinated debt and reducing their reliance on senior unsecured claims. We use industry level changes in tariffs and exchange rates to instrument for exogenous changes in volatility. Overall, we find that increases in volatility are associated with reductions in the use of debt, and a shift in debt structure towards secured bank debt, subordinated and convertible debt, and away from reliance on senior unsecured debt. Consistent with an increase in creditor control rights we find that increases in volatility are associated with an increase in covenant intensity of new debt issues.