In an efficient market, spreads will reflect both the issuer’s current risk and investors’ expectations about how that risk might change over time. Collin-Dufresne and Goldstein (2001) show analytically that a firm’s expected future leverage importantly influences the spread on its bonds. We use capital structure theory to construct proxies for investors’ expectations about future leverage changes and find that these significantly affect bond yields, above and beyond the effect of contemporaneous leverage. Expectations under the trade-off, pecking order, and credit-rating theories of capital structure all receive empirical support, suggesting that investors view them as complementary when pricing corporate bonds.

Unlike seasoned equity or public debt offerings, bank loan financing elicits a significantly positive announcement return, which has led financial economists to characterize bank loans as “special.” Here, we find that firms announcing bank loans suffer negative abnormal stock returns over the subsequent three years. In the long run, bank loans appear no different from seasoned equity offerings or public debt issues. Our evidence suggests that larger loans (relative to borrower equity) are followed by worse stock performance. We also find that lender protection is negatively related to borrower performance, suggesting the lender is somewhat shielded from the poor performance.

We study 6,083 European firms that were acquired between 1999 and 2015. Soon after the acquisition, the acquired firms promptly and substantially close the gap between their actual leverage ratios and their target (optimal) ratios. Firms that were over- (under-) leveraged at the start of their acquisition year move their debt-to-assets ratio from 34.1% to 20% (10% to 18.5%) by the end of the following year. Under-leveraged firms expand their assets rapidly following acquisition, as they gain improved access to investable resources. Our results are consistent with the trade-off theory of capital structure and with the existence of firm-specific target leverage ratios.