Leverage Choice and Credit Spread Dynamics When Managers Risk Shift
68 Pages Posted: 17 Feb 2009
Date Written: February 15, 2009
We provide new insights that link compensation structure terms to credit spreads by modeling the dynamic risk choice of a risk-averse manager paid with performance insensitive pay (cash) and performance sensitive pay (stock). The model predicts that credit spreads are increasing in the ratio of cash-to-stock. When the manager has discretion to choose debt levels, a trade-off between tax benefits and utility cost from ex-post asset substitution arises. The resulting optimal initial leverage is high with safe (risky) debt when cash-to-stock ratios are low (high), while moderate cash-to-stock ratios are associated with low initial leverage. In an empirical exercise using a large cross-section of 608 US based corporate credit default swaps (CDS) covering 2001-2006, we find strong evidence that CDS rates are high for CEOs with high salaries relative to stock and option holdings.
Keywords: compensation structure, credit spread, CDS rates, leverage
JEL Classification: G32
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