Duration of Corporate Debt Issues

INTRODUCTION Numerous theoretical and empirical studies have investigated the different factors that firms consider when choosing the maturity of their debt issues. In this paper, the duration of debt issues is examined. Some questions about the determinants of debt maturity may also be answered by examining firms' duration choices. Duration measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future. Debt maturity focuses more on matching the cash flow generated from the chosen project to the life of the project. Research comparing both approaches (duration and maturity) may discern whether firms focus on duration or maturity. Hypotheses that have been offered to explain corporate debt maturity are used to examine the firms' duration choices to see if factors that influence maturity choices also affect bond duration. Using a sample of debt issues from the Thomson Financial SDC Platinum database, the determinants of the durations of 8,627 public, non-convertible corporate debt instruments placed in U.S. markets between January 1, 1990 and December 31, 2002 are documented. How signaling and asymmetric information as well as agency problems are related to bond duration is also examined. This paper is organized as follows: The following sections provide a comprehensive examination of the theories surrounding debt maturity and bond duration, including a set of testable hypotheses. A description of the data obtained for analysis is provided, and the models and results are then presented. The conclusions of this paper are presented in the final section. THEORIES AND HYPOTHESES Theories and hypotheses that have been offered to explain corporate debt maturity are used to examine the firms' duration choices to determine if factors that influence maturity choices also affect bond duration. Specifically, how signaling and asymmetric information as well as agency problems are related to bond duration is investigated. SIGNALING AND ASYMMETRIC INFORMATION Flannery (1986) examines the maturity structure of a firm's risky debt using a model of uncertainty where debt serves as a signal of credit quality. The model indicates that, given low costs for debt issuance, high-quality firms will issue short-term debt when they expect to benefit from bondholder scrutiny during the refinancing process, while low-quality firms issue long-term debt to avoid re-evaluation. On the other hand, abnormally high refinancing costs will lead to a pooling equilibrium where both high-quality and low-quality firms issue long-term debt. The risk of not being able to refund debt because of deterioration in financial or economic conditions can motivate firms to lengthen the maturity of their debt. Sharpe (1991) and Titman (1992) suggest that unfavorable news about a borrower may arrive on the refinancing date, causing investors not to extend credit or to raise default premia on new debt issues. Diamond (1991) refers to this refinancing risk as a liquidity risk in that the borrower is forced into an inefficient liquidation because refinancing is unavailable. Diamond (1991) builds on Flannery's (1986) paper by suggesting that high-quality firms indeed desire short-term debt but face the risk that refinancing may be unavailable, forcing liquidation and loss of control. Thus, the optimal maturity structure is decided by a trade-off between its preference for short-term debt based on an expected improvement in credit rating and greater liquidity risk. While liquidity risks give some firms an incentive to borrow long-term, such firms may not be able to do so because the rate of return required to compensate investors for bearing long-term credit risks can induce firms to take risky low-quality projects. According to Diamond (1991), there are two categories of short-term borrowers: high-rated borrowers using short-term debt to take advantage of the arrival of information and low-rated borrowers who are screened out of the long-term debt market because lenders want to keep them on a short leash. …