What Do Credit Markets Tell Us About the Speed of Adjustment?
University of Toronto - Rotman School of Management
Raunaq S. Pungaliya
Sungkyunkwan University (SKK) Graduate School of Business
Anand M. Vijh
University of Iowa - Department of Finance
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.
Number of Pages in PDF File: 47
Keywords: Target leverage, tradeoff theory, speed of adjustment, pecking order, market timing, bond pricing
JEL Classification: G32, G12
Date posted: February 15, 2012 ; Last revised: January 22, 2013