The Agency Credit Spread
72 Pages Posted: 1 Jan 2014 Last revised: 16 Feb 2018
Date Written: February 10, 2018
Lack of shareholders' commitment about debt and investment policies, although mitigated by debt covenants, maturity, and other contractual provisions, contributes a significant part of the firm's cost of debt, which we refer to as the agency credit spread (ACS). We propose a dynamic model of investment and financing, in which we characterize the debt protection against agency distortions as a reduced form specification of the value function. The model features long-term debt and allows for several possible distortions of the optimal policy, including debt claim dilution, underinvestment, and asset stripping. After structural estimating the parameters of the model, we are able to measure the agency credit spread at about 39% of the average credit spread in the sample. We show that the shareholders' incentive to deviate from debt policies aimed at maximizing the value of the firm, the 'leverage ratchet effect,' is at least as important as underinvestment, the 'debt overhang effect,' in transferring wealth from debt to equity.
Keywords: corporate credit risk, credit spread, structural models, debt-equity agency conflicts
JEL Classification: G12, G31, G32, E22
Suggested Citation: Suggested Citation