Debt Maturity and Growth Options
53 Pages Posted: 18 Dec 2017 Last revised: 27 Apr 2020
Date Written: April 26, 2020
When a firm issues short-term debt, it trades off lower rollover losses today for higher rollover frequencies tomorrow, leading to an endogenous earlier default. However, in equilibrium, when firms roll over bonds of different maturity, their debt-maturity structure can feature both shorter and longer average maturity in bad times. We link these debt-maturity patterns to the firms' fundamentals, in a model in which operational income is deterministically declining, but where the same firm is subject to a growth option.
Larger growth options induce paths in which the fraction of outstanding short-term debt falls in bad times---a procyclical rollover policy. For a sufficiently large upside option, this pattern is the only equilibrium type, whereby firms engineer later default via longer maturity. By contrast, the fraction of newly issued short-term debt is (weakly) procyclical, in all paths. That is, more short-term (less long-term) debt is issued in good times than in bad times; in other words, less and less short-term debt is issued in the run up to default.
Keywords: Dynamic debt maturity, Endogenous default, Rollover and credit risk, Outstanding and newly-issued debt, Growth options
JEL Classification: G32, G11
Suggested Citation: Suggested Citation