This paper develops a framework for analyzing the impact of macroeconomic conditions on credit risk and dynamic capital structure choice. We begin by observing that when cash flows depend on current economic conditions, there will be a benefit for firms to adapt their default and financing policies to the position of the economy in the business cycle phase. We then demonstrate that this simple observation has a wide range of empirical implications for corporations. Notably, we show that our model can replicate observed debt levels and the countercyclicality of leverage ratios. We also demonstrate that it can reproduce the observed term structure of credit spreads and generate strictly positive credit spreads for debt contracts with very short maturities. Finally, we characterize the impact of macroeconomic conditions on the pace and size of capital structure changes, and debt capacity.

We study a novel aspect of a firm’s capital structure, namely, the profile of its debt maturity dates. In a simple theoretical framework we show that the dispersion of debt maturities constitutes an important dimension of capital structure choice, driven by firm characteristics and debt rollover risk. Guided by these predictions we establish two main empirical results. First, using an exogenous shock to rollover risk, we document a significant increase in maturity dispersion for firms that need to roll over maturing debt. Second, we find strong support that maturities of newly issued debt are influenced by pre-existing maturity profiles.

We study the interplay between corporate liquidity and asset reallocation. Our model shows that financially distressed firms are acquired by liquid firms in their industries even in the absence of operational synergies. We call these transactions “liquidity mergers,” since their purpose is to reallocate liquidity to firms that are otherwise inefficiently terminated. We show that liquidity mergers are more likely to occur when industry-level asset-specificity is high and firm-level asset-specificity is low. We analyze firms' liquidity policies as a function of real asset reallocation, examining the trade-offs between cash and credit lines. We verify the model's prediction that liquidity mergers are more likely to occur in industries in which assets are industry-specific, but transferable across firms. We also show that firms are more likely to use credit lines (relative to cash) in industries in which liquidity mergers are more frequent.

We document that (i) debt-to-equity ratios and levered equity betas negatively covary with the market risk premium in distressed firms; (ii) the negative covariance generates negative alphas among those firms. We build a dynamic credit risk model to understand the negative covariance between equity betas and the market risk premium, via endogenous and dynamic debt financing over the business cycles. Because of endogenous debt financing and distress, our model naturally connects the negative failure probability-return relation to the positive distress risk premium-return relation.