The Agency Credit Spread
University of Warwick - Finance Group
University of Navarra - Business
University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics
December 31, 2013
Using a neoclassical structural model with dynamic investment and long-term debt financing decisions, we show that debt-equity agency conflicts can contribute a significant part of the credit spread on corporate bonds, which we refer to as the agency credit spread. This spread reflects the incentive of shareholders to deviate from optimal policies that maximize the entire value of the firm (equity plus debt). This is achieved by dynamically exploiting existing unprotected bondholders by diluting their debt claims and under-investing so as to increase the shareholders payout. These effects are inherently countercyclical, in that they are higher in economic downturns and when the firm approaches financial distress. We delineate some testable implications by relating variations in agency credit spreads to variations in some aspects of the model that are conducive of agency conflicts and that can be linked to observable firm characteristics. We confirm those testable implications in a sample of large S&P 500 firms. Under the assumption that the strength of agency frictions is a relevant contributor to credit spreads, we find a positive correlations between changes in credit CDS spreads and changes in asset specificity, operating leverage, and the maturity mis-match between liabilities and assets of the firm.
Number of Pages in PDF File: 55
Keywords: corporate credit risk, credit spread, structural models, debt-equity agency conflicts
JEL Classification: G12, G31, G32, E22
Date posted: January 1, 2014
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