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Article Excerpt
Abstract Recent work in corporate finance has suggested that strategic debt-service by equity-holders works to lower debt values and raise yield spreads substantially. We show that this is not quite correct. With optimal cash management, defaults occassioned by deliberate underperformance (strategic defaults) and those forced by inadequate cash (liquidity defaults) work as substitutes: allowing for strategic debt-service leads to a decline in the equilibrium likelihood of liquidity defaults. In some cases, this decline is sufficiently sharp that equilibrium debt values actually increase and yield spreads decline. We provide an intuitive explanation for these results in terms of an interaction of optionalities.
Keywords Strategic debt-service * Optimal cash management * Liquidity defaults * Strategic defaults * Yield spreads
JEL Classification Numbers G13 * G33 * G35
1 Introduction
Since its introduction by Hart and Moore (1989, 1994), the notion of strategic debt-service has received considerable attention in the finance literature. At its core, strategic debt-service involves a simple idea: when liquidation is costly, it may be possible for equity holders to under-perform on their debt-servicing obligations without triggering liquidation, since rejecting the offer and liquidating the firm may leave debt holders even worse off. The idea is an attractive one; it indicates that default may occur not just because the firm lacks adequate cash (liquidity defaults), but also because of opportunistic behavior by equity holders (strategic defaults).
These observations appear to imply that allowing for strategic debt-service makes debt "more" risky and should result in a lowering of debt values and widening of yield spreads. In this paper, we examine whether such an implication is, in fact, valid. More generally, we look to identify conditions under which strategic debt-service has a large impact on debt values and when it does not.
Our main results are simply stated. We find that liquidity and strategic defaults are not so much complements that reinforce each others' impacts, as substitutes: that is, introducing the ability to service debt strategically typically reduces the equilibrium likelihood of liquidity-driven defaults. The extent of reduction is greater the higher is the cost to the firm of raising new capital. For firms with a high cost of raising new capital, allowing for strategic debt-service may result in a substantial decline in liquidity-driven defaults, leading to a negligible effect on debt values and yield spreads; remarkably, in some cases, it may even lead to an increase in debt value and a narrowing of spreads. However, for firms with a low cost of raising new capital, the widening effect of strategic debt service on yield spreads can be very substantial.
The intuition behind these results may be put in terms of an "interaction of optionalities," specifically, between the option to carry cash reserves and the option to service debt strategically. When the cost of raising new funds is high, firms can avoid financial distress and costly liquidation by exercising the first option and carrying larger cash reserves within the firm. However, this involves a possible cost: if distress becomes unavoidable, debt holders have first claim on the firm's assets including these reserves. The second option, that of strategic debt-service, compensates for this partially: it ensures that in the non-liquidation states, "excess" reserves (those over the minimum debt-service required to avoid liquidation) accrue to equity holders rather than debt holders. Absent this option, these reserves continue to accrue to the benefit of debt holders until debt-servicing obligations are fully met.
Thus, the option to carry forward cash reserves is more valuable to equity holders when the option to service debt strategically is also present. This leads to higher cash reserves under strategic debt-service, and so to fewer liquidity defaults. In turn, this offsets at least partially the negative impact on debt values of strategic debt service. In some cases, the net result is even higher debt values under strategic than non-strategic debt-service.
Our results clarify and extend the recent work of Anderson and Sundaresan (1996) and Mella-Barral and Perraudin (1997) which have received much attention. The papers each develop cash-flow based extensions of the Merton (1974) risky-debt valuation model into which strategic debt-service considerations are introduced. Each paper reports that equilibrium yield spreads are substantially wider when debt-service is strategic than when it is non-strategic.
However, neither paper considers optimal management of the periodic cash flows from the operation of the firm; rather, both assume that all cash flows left over after debt service must be paid out as dividends to equity holders. Thus, the introduction of strategic debt-service does not affect the likelihood of liquidity-driven defaults in the models. Moreover, Mella-Barral and Perraudin (1997) assume that the firm can raise new equity costlessly. At the other extreme, Anderson and Sundaresan (1996) assume this process is infinitely expensive: no new issue of securities is permitted in their model.
By allowing for optimal cash management as well as for costs of new equity issuance (which may range from zero to infinity), our paper generalizes both sets of assumptions. We confirm the finding of Mella-Barral and Perraudin (1997) that with zero costs of new equity issuance, strategic debt-service has a substantial widening effect on equilibrium spreads. However, we find that under the conditions of the Anderson and Sundaresan (1996) paper, strategic debt-service typically has a negligible widening effect on yield spreads, and, more damagingly, may even narrow spreads in some cases! These conslusions remain true even if the optimal cash management of our paper is replaced with their assumption of no cash management. Thus, our findings contradict theirs. Section 3.3 explains the discrepancy.
Some general points of resemblance between our analysis and others in the literature bear mention. In a paper focussing on the optimal design of debt contracts, Bolton and Scharfstein (1996) make the point that there may be a trade-off between liquidity and strategic defaults. Our analysis, conducted in a very different setting, also points to this tension. In both cases, the riskiness of debt does not increase solely as a consequence of allowing for additional types of default.
That the interaction of optionalities could lead to apparently paradoxical conclusions has also been noted in other contexts recently. Myers and Rajan (1998) describe a "paradox of liquidity" where greater liquidity (the ability to convert assets to cash) could reduce a firm's debt capacity. Morellec (2001) shows that asset liquidity increases debt capacity only when bond covenants restrict disposition of assets; by contrast, greater liquidity increases credit spreads on unsecured corporate debt. Titman, Tompaidis, and Tsyplakov (2000) also find that "deep pocket" borrowers under certain conditions could face greater borrowing costs than do "credit constrained" borrowers.
Our results have implications for empirical research attempting to relate the extent of strategic debt-service to yield spreads. Our finding that strategic debt service matters more for firms with a low cost of accessing outside capital suggests that empirical studies should control in the cross-section of firms for this cost, perhaps by using the firm's credit rating. More generally, our results imply that the large number of options equity holders have in practice do not necessarily all work against the interests of the firm's creditors. Empirical work on the agency-theoretic determinants of credit spreads should thus be careful in accounting for such possibilities.
The remainder of this paper has the following structure. Section 2 presents the outline of our...
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