What Do Credit Markets Tell Us About the Tradeoff Theory and Speed of Adjustment?

Abstract

This article proposes a methodology to infer investors’ expectations about the speed at which firms adjust to their target leverage. We find that in the long run bond and CDS investors expect leverage to converge towards a target as suggested by the tradeoff theory. On average, the credit markets imply a fairly rapid annual speed of adjustment of 26%. However, we also find strong support that in the short run the expected adjustment process implicit in the prices of credit instruments is affected by transaction costs, pecking order, and market timing. Overall, we show that one can learn about capital structure speed of adjustment not just from realized leverage changes, but also from expectations embedded in market prices.