The Maturity Structure of Corporate Debt

Since Myers’ (1977) research, a number of studies have investigated the factors which influence the maturity structure of corporate debt, and the literature which delves deeply into this issue offers different kinds of hypotheses about the determinants. In this section, we compile the research and contemplate these hypotheses successively.

I. Contracting Cost Hypothesis

Myers (1977) states that underinvestment problem occurs in the firms with risky debt financing, and he argues that decision of debt maturity can reduce conflicts between shareholders and bondholders. When firms with risky debt financing in their capital structure proceed with the investment projects, profit gained from the projects has to be divided up between shareholders and bondholders. Bondholders can always reap a fixed amount of profit from investment projects; however, sometimes shareholders may not gain the satisfied normal return. Thus, it is possible for shareholders to give up some positive net present value investment projects.

Consequently, underinvestment problem for bondholders occurs. Myers argues that issuing short-term debt can eliminate unwillingness to invest when short-term debt matures before the date to exercise the investment options. Thus, Myers infers that firms having more growth options in their investment projects should issue shorter-term debt in their capital structure.

Barclay and Smith (1995) and Stohs and Mauer (1996) argue that firm size also plays a substantial role on debt maturity determination. Barclay and Smith state that issuance costs of public issues possess a large amount of fixed costs and have scale economics. Small firms which cannot easily gain the advantage of scale economics will prefer private debt to public debt and therefore have more short-term debt. On the other side, Stohs and Mauer argue that small firms have more opportunities to face other types of conflicts between shareholders and bondholders, so they are willing to issue more short-term debt to remove these conflicts.

Smith (1986) also argues that regulated firms have longer-maturity debt than unregulated firms because the managers of regulated firms have less discretion upon future investment decisions.

II. Signaling and Liquidity Risk Hypotheses

Flannery (1986) does research about the decision of corporate debt maturity in terms of signaling. When information asymmetry exists in the bond market, outside investors may misunderstand the true quality of firms, and then firms with high quality suffer.¹ If debt issuing is costless, only a pooling equilibrium of short-term debt occurs because low-quality firms can mimic high-quality firms’ choices without paying any additional cost. Hence, the long-term debt market ceases to operate.

However, high-quality firms can sometimes signal their true quality to investors

1 Flannery establishes a two-period model of debt maturity choice under information asymmetry to show the negative misinformation value, which reduces firms’ value, of high-quality firms in the pooling equilibrium.

effectively when transaction costs are positive. Low-quality firms will self-select to issue long-term debt if costs of mimicking high-quality firms’ choices, i.e. rolling over short-term debt, are too high for them. Therefore, a separate equilibrium is achievable when high-quality firms choose to issue short-term debt in order to signal their true value. Flannery argues that different outcomes of equilibriums depend on the distribution of firms’ quality and the magnitude of underwriting costs for corporate debt.

Diamond (1991) develops a different signaling model about credit rating to analyze debt maturity structure. Although firms with private information about future profitability like to issue short-term debt in order to gain a benefit from refinancing, firms also encounter the liquidity risk that leads to be incapable of raising new funds at the same time. Diamond argues that different levels of firms’ credit rating influence the decision of debt maturity. For firms with highest credit rating, it is more possible to issue short-term debt because these firms face smaller refinancing risk. Besides, firms with lowest credit rating also issue short-term debt because they have high opportunity of having no enough income to support the long-term debt. Finally, firms with credit rating between these two types of firms issue more long-term debt. In this paper, Diamond presents that the relationship between debt maturity and borrowers’

credit rating is not a monotonic function.

For testing empirically the theories of Flannery and Diamond to see the effects of risk and information asymmetry upon determining debt maturity, Berger, Espinosa-Vega, Frame, and Miller (2005) collect 6,000 commercial loans from 53 large U.S. banks as data and use small business credit scoring (SBCS) technology being used to reduce information asymmetries. Empirical research results in this paper have the same conclusion with Flannery’s and Diamond’s only for low-risk firms.

Debt maturity is an upward-sloping function of risk rating for these firms. This paper

also confirms the notion that information asymmetry plays a critical role in determining corporate debt maturity.

Besides, leverage is also concerned in viewpoint of liquidity risk in Stohs and Mauer’s (1996) paper. Because firms with higher leverage may face more liquidity risks than firms with lower leverage, they will have stronger incentive to use longer-term debt.

III. Matching Hypothesis

Matching principle is mentioned in Stohs and Mauer’s (1996) research. Earlier papers such as Myers’ (1977) and Barclay and Smith’s (1995) also explained this hypothesis.² Myers argues that firms matching their debt maturity to asset maturity can avoid the agency conflicts between shareholders and debt investors by assuring that debt repayments can be scheduled to correspond with the decline in future value of assets. Thus, Stohs and Mauer also argue that the maturity of debt changes positively with that of assets.

On the other hand, Morris (1976) advances that making debt maturity approximately equal to assets life may not be the least risky maturity policy. Morris explores the effects of debt maturity on variance of net income and argues that the correlation between interest rates and net operating income influences the optimal debt maturity choice. For long-term assets, long-maturity debt has the advantage to decrease the uncertainty risk of interest rates. Nevertheless, short-term debt can mitigate the uncertainty of net income obtained from assets when the covariance of future interest rates and net operating income is positive highly. Hence, Morris argues that departing from the hedging policy which matches debt maturity to assets maturity may reduce the fluctuation of net income and the risk to the shareholders.

2 Barclay and Smith (1995) argue that the maturity of a firm’s intangible assets can also be a determinant of the maturity of corporate debt when they analyze Myers’ (1977) research about matching hypothesis.

IV. Taxation Hypothesis

Controversial conclusions about taxation hypothesis are presented in previous paper. Brick and Ravid (1985) argue that firms like to issue more short-term debt when the term structure has a negative slope. Based on expectation hypothesis, it is rational that issuing short-term debt can increase the firm’s value when the term structure’s slope is negative because of expected lower short-term interest rate in the future. Brick and Ravid (1991) expand the tax-based debt maturity model and argue that uncertainty of interest rates causes a favor for long-maturity debt. However, Lewis (1990) argues that taxation is not an effective determinant of optimal debt maturity and the debt maturity structure is irrelevant with the firm’s value.

V. The Manager’s behavior and Debt Maturity Structure

Datta, Iskandar-Datta, and Raman (2005) argue that managerial stock ownership is also a critical factor influencing corporate debt maturity structure.³ Agency problem between managers and shareholders happens because the interests of managers do not align those of shareholders. Less outside monitoring which the manager encounters will aggravate the conflict more seriously. Hence, Datta, Iskandar-Datta, and Raman infer that short-term debt can alleviate the conflict because it subjects managers to more frequent monitoring from investors and underwriters. It is rational to believe that more long-term debt is issued if the alignment of interests between shareholders and managers is fragile.