62 Pages Posted: 1 Jan 2014 Last revised: 13 May 2015
Date Written: May 13, 2015
We study the impact of agency frictions on the price of defaultable debt in the context of a structural model of corporate decisions. Our model features dynamic investment and long-term debt financing, thus allowing us to analyze many types of possible agency distortions: under- and over-investment, debt claim dilution and excess dividend distributions. We show that shareholders’ incentives to deviate from firm (i.e., equity plus debt) value optimizing policies contribute a significant part of a firm’s credit spread, which we refer to as the agency credit spread. As deviations from firm value maximizing policies are most significant when the firm approaches financial distress, typically in economic downturns, the agency credit spread is large. We find that the mismatch in the maturity of assets and liabilities, the liquidation cost of assets, and the operating leverage of the firm are positively associated with the theoretical agency credit spread. We confirm those predictions in a sample of large S&P500 firms.
Keywords: corporate credit risk, credit spread, structural models, debt-equity agency conflicts
JEL Classification: G12, G31, G32, E22
Suggested Citation: Suggested Citation