The Agency Component of Credit Spread

Abstract

Lack of shareholders' commitment about debt and investment policies increases the cost of debt by a quantity that we refer to as the agency (credit) spread. The agency spread increases with the number of periods for which debt holders are exposed to policies that decrease the value of debt: from 10 basis points or equivalently 5.4% of the average credit spread at one year horizon to 44 basis points and 27%, respectively, at fifty years horizon. At short horizons, small firms with valuable growth options have larger agency spreads. At longer horizons, conversion of options into assets in place and the leverage ratchet effect invert the relationship and deliver higher agency costs for large firms, delivering a non-trivial term structure of the agency credit spread.

Keywords: corporate credit risk, credit spread, structural models, debt-equity agency conflicts

JEL Classification: G12, G31, G32, E22