Junk Bonds, Bank Debt, and Financial Flexibility

Posted: 20 Jul 1998

See all articles by Stuart C. Gilson

Stuart C. Gilson

Harvard Business School - Finance Unit

Jerold B. Warner

University of Rochester – Simon Business School

Date Written: October 1997


New issues of public high yield debt, or junk bonds, reached record levels in the 1990s. This paper studies transactions where firms issue junk bonds and use the proceeds to repay their bank debt. These substitutions represent the most frequent use of junk bonds. Our analysis suggests that firms undertake these substitutions to preserve financial flexibility--a capital structure's ability to support activities at low transaction and opportunity cost. Junk bond substitutions typically occur around negative earnings surprises. Since junk bonds contain substantially fewer and less restrictive covenants than bank debt, and also mature later, these substitutions reduce the probability of default and increase the range of activities in which firms can engage. The earnings surprises are short-term, and firms eventually reborrow from banks. Junk bond issues convey negative information about sample firms' prospects and cause stock prices to fall, but the decline is less severe for firms that benefit more from the increased financial flexibility. While giving managers increased flexibility could also harm shareholders (by allowing them to take actions that reduce firm value) our evidence does not strongly support this possibility.

JEL Classification: G32

Suggested Citation

Gilson, Stuart C. and Warner, Jerold B., Junk Bonds, Bank Debt, and Financial Flexibility (October 1997). Available at SSRN: https://ssrn.com/abstract=7944

Stuart C. Gilson (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
(617) 495-6243 (Phone)
(617) 496-8443 (Fax)

Jerold B. Warner

University of Rochester – Simon Business School ( email )

Carol Simon Hall 3-160H
Rochester, NY 14627
United States
585-275-2678 (Phone)
585-442-6323 (Fax)

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