Corporate debt structure: The long and the short of it

• Published date: 01 April 2023
• Author: Steven P. Clark,Min C. Park
• Date: 01 April 2023
• DOI: http://doi.org/10.1002/jcaf.22601

Received:  August  Accepted:  October 

DOI: ./jcaf.

RESEARCH ARTICLE

Corporate debt structure: The long and the short of it

Steven P. Clark1Min C. Park2

Belk College of Business, University of

North Carolina Charlotte, Charlotte,

North Carolina, USA

College of Business Administration,

Alabama State University, Montgomery,

Alabama, USA

Correspondence

Steven P.Clark, Belk College of Business,

University of North Carolina Charlotte,

Charlotte, NC, USA.

Email: spclark@uncc.edu

Abstract

Consistent with the existence of a rollover risk channel, we document that an

increase in short-term debt proportional to the total debt increases the cost of

long-term debt. The effect of rollover risk is more pronounced for the firms

that are vulnerable to unforeseen negative events. Moreover, we find that the

marginal effect of short-term debt on the yield spread is intensified during peri-

ods of market illiquidity. Finally, our results suggest that this positive effect on

the yield spread due to increased rollover risk is partially offset by a negative

effect due to the attenuation of underinvestment problems.

KEYWORDS

agency problems, corporate bonds, debt maturity, rollover risk

JEL CLASSIFICATION

G, G, G

1 INTRODUCTION

Much progress has been made in the financial eco-

nomics literature toward identifying the determinants of

corporate-Treasury yield spreads and on understanding

the contributions of each relevant factor.Froma theoreti-

cal perspective, default risk has long occupied a position

of central importance in this discussion. Assuming that

a firm will default if the value of its debt exceeds the

value of its assets, structural credit risk models seek to

quantify the potential for endogenous default and its con-

sequences for corporate bond prices.A straightforward

The corporate-Treasury yield spread, or simply yield spread, of a cor-

porate bond is the yield of the bond minus the yield of a U.S. Treasury

security of the same maturity. It is also frequently referred to as the

credit spread of the corporate bond. In this paper, we use these terms

interchangeably.

For more details on structural models, see Geske (), Smith and

Warn er (), Longstaff and Schwartz (), Leland and Toft (),

Collin-Dufresne et al. ().

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any medium,

provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.

©  The Authors. Journalof Corporate Accounting & Finance published by Wiley Periodicals LLC.

implication of this first-passage time default mechanism is

that an increase in a firm’s leverageratio intensifies default

risk, and consequently, increases the yield spreads on its

bonds. However,default risk alone is not enough to explain

observed corporate yield spreads. Many additional factors

have been studied including a tax premium and a mar-

ket risk premium (Elton et al., ), idiosyncratic equity

volatility (Campbell & Taskler, ), liquidity premium

(Longstaff et al., ; Chen et al., ; He & Xiong, ),

and firm-specific information (Kwan, ). This paper

examines the relationship between a firm’sshort-term debt

in proportion to total debt and the yield spreads on its

bonds.

Within the capital structure literature, there have been

numerous studies focusing on debt structure. Starting with

Myers (), it has been generally accepted that the use

of debt financing by firms with growth options can lead

to suboptimal investment decisions. The essence of the

argument is that debt can create agency problems in firms

with growth options. Managers, acting on behalf of equity

J Corp Account Finance. ;:–. wileyonlinelibrary.com/journal/jcaf 149

150 CLARK  PARK

holders, may pursue low-risk projects and forego higher-

risk investments in growth options if the benefits from

these projects must be shared with creditors. Myers ()

argues that debt maturity can be chosen to reduce such

underinvestment problems. Specifically,debt that matures

before an investment decision is made will not affect the

decision. Many studies (Barclay & Smith, ; Guedes &

Opler, ; Barclay et al., ) support Myers’ prediction

about firms’ debt maturity preferences. Johnson ()

and Billett et al. () also find evidence that short-term

debt mitigates the negative effect on the firm’s leverage.

On the other hand, the use of short-term debt is not

without disadvantages. Diamond () introduces liquid-

ity risk (i.e., rollover risk) as the risk of a borrower being

forced into inefficient liquidation when refinancing is not

available. Sharpe () and Titman () suggest that

unfavorable news about a borrower may arrive during

refinancing times, possibly raising the default premium

on new debt or even dissuading investors from extend-

ing credit. In the Diamond () model, a firm with a

sufficiently high credit rating using short-term debt could

successfully lower its cost of debt if positive information

is revealed during the subsequent refinancing. However,

the use of short-term debt exposes the issuer to liquidity

risk. Due to this trade-off, the model predicts three differ-

ent types of borrowers: () short-term borrowers with high

credit ratings who expect good news will arrive lowering

their cost of debt in the future, () long-term borrowers

for whom rollover risk from short-term debt outweighs

potential savings in financing costs, and () borrowers with

very low credit ratings for whom short-term debt is the

only option available in the market. Barclay& Smith ()

and Mark & Mauer () find evidence in support of

Diamond’s rollover risk hypothesis.

The interaction between liquidity risk and default risk

confounds efforts to measure their respective contribu-

tions to yield spreads. As suggested by the model of He

&Xiong(), there may exist a rollover risk channel

through which debt market illiquidity affects corporate

bond spreads. In a sample of corporate bonds sold in

international markets from January  to June ,

Valenzuela () documents evidence of such a rollover

risk channel, finding that during periods of market illiq-

uidity, the widening of yield spreads produced by high

levels of short-term debt to total debt is intensified.

In this paper, we will clarify the relationship between a

firm’s choice of debt maturity structure and its cost of long-

term debt. Our empirical results are consistent with an

overall conclusion: Short-term debt increases yield spreads

and this effect is mediated through a rollover risk chan-

nel. The effect of short-term debt on a firm’s credit spread

is more pronounced for firms that are more vulnerable to

negative consequences from unforeseen and unfavorable

events. Moreover, the marginal effect of short-term debt

on the yield spread is intensified during periods of market

illiquidity. Finally, we document a result that, to the best

of our knowledge, is completely novel to the literature. We

find a positive relationship between the market-to-book

ratio and the cost of long-term debt, but this effect is mit-

igated for firms using short-term debt. Thus, short-term

debt has two distinct and opposite effects on credit spreads

for firms with growth opportunities. A positive effect due

to increased rollover risk is partially offset by a negative

effect due to the attenuation of underinvestmentproblems.

Although some of the findings mentioned above are

similar to those of previous studies (e.g., Gopalan et al.,

), there are some key differences in our data set

and econometric methodologies. Our sample consists of

, bond-month observations using , different

bonds issued by  different firms during –,

a period that includes the Great Financial Crisis (GFC)

and subsequent recovery. We consider several different

model specifications to ensure robustness of our results. In

addition to pooled OLS regression, we address the poten-

tial issue of time-varying firm characteristics by applying

a fixed effects model in a panel-data framework. Con-

trolling for the potential endogeneity of short-term debt,

we also employ instrumental variables (IV) regression

using a novel identification strategy for short-term debt

in proportion to total debt. Furthermore, recognizing that

the causal relationship between debt maturity and credit

spread could be more complicated than a simple one-way

specification reflects, we employ a simultaneous equation

model (SEM). Finally, to control for dynamic endogeneity

and simultaneity, we apply a dynamic generalized method

of moments (GMM) model. Our results remain robust

across these different models.

This remainder of this study is organized as follows.

We develop our hypotheses for this study in the next

section. Variables and sample selection are presented in

Section . Our econometric methodology is discussed, and

our results are presented and interpreted in Section .

Section summarizes and concludes.

2HYPOTHESIS DEVELOPMENT

Diamond () argues that the debt maturity choice is

a trade-off between a borrower’s preference for short-

term debt, due to private information about the future

credit rating, and liquidity risk. Moreover, Leland & Toft

() numerically illustrate that shorter debt maturity can

lead a firm to default at a higher fundamental bound-

ary. Many empirical studies in the literaturesupport these

arguments. For example, firms with higher short-term

debt to total debt are more likely to be downgraded