Leverage Choice and Credit Spread Dynamics When Managers Risk Shift

Abstract:     
We provide new insights that link compensation terms to credit spreads and leverage by structurally modeling the financial and operating decisions of a risk-averse manager paid with cash and stock. Optimal debt balances tax benefits with the utility cost resulting from ex-post asset substitution. When cash-stock ratios are low (high), initial leverage is high and debt is safe (risky), while moderate cash-stock ratios are associated with low initial leverage. High credit spreads can be generated even when leverage and equity volatility are low. Using a large cross-section of 646 US based corporate credit default swaps (CDS) covering 2001-2006, we find strong evidence that the flexibility provided by the compensation terms is important for explaining CDS rates. With parameters estimated to match moments based on stock volatility and CDS rates, our model outperforms a similarly calibrated version of the Merton (1974) model, explaining an additional 10% of the variation in CDS rates and reducing average bias by over 50%.

Number of Pages in PDF File: 68

Keywords: Capital structure, credit spreads, managerial compensation

JEL Classification: G32

working papers series