[We analyze determinants of secondary debt market liquidity, identifying conditions under which a large investor can profitably buy stakes from small bondholders and offer unilateral debt relief to a distressed firm. We show that endogenous trading by small bondholders may result in multiple equilibria. Some equilibria entail vanishing liquidity and sharp increases in yields absent changing fundamentals. In turn, anticipation of illiquid equilibria induces firms to eschew public debt financing, since such equilibria create higher bankruptcy costs and debt illiquidity discounts. The model thus offers a rational micro-foundation for stylized facts commonly attributed to investor sentiment and CFO market timing. Finally, we show that the vulnerability of debt markets to multiple equilibria is highest during downturns, when small bondholders face severe adverse selection.]

We develop and empirically test a theory of optimal security design under adverse selection accounting for strategic trading by uninformed investors who will liquidate a security in secondary markets only if their idiosyncratic carrying costs exceed the security's expected trading loss. Such investors demand primary market discounts equaling expected carrying costs borne plus trading losses incurred. Issuers minimize the total illiquidity discount by splitting cash-flow into tranched debt claims with liquidity predicted to increase with seniority, while the optimal number of tranches increases with underlying cash-flow risk. Empirical tests confirm our model predictions.

[As an alternative to the pecking order, we develop a dynamic calibratable model where the firm avoids mispricing via signaling. The model is rich, featuring endogenous investment, debt, default, dividends, equity flotations, and share repurchases. In equilibrium, firms with negative private information have negative leverage, issue equity, and overinvest. Firms signal positive information by substituting debt for equity. Default costs induce such firms to underinvest. Model simulations reveal that repeated signaling can account for countercyclical leverage, leverage persistence, volatile procylical investment, and correlation between size and leverage. The model generates other novel predictions. Investment rates are the key predictor of abnormal announcement returns in simulated data, with leverage only predicting returns unconditionally. Firms facing asymmetric information actually exhibit higher mean Q ratios and investment rates.]

[We examine the optimal mixture and priority structure of bank and market debt using a trade-off model in which banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior trade-off between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the trade-off theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The trade-off theory also generates predictions consistent with international evidence. In countries in which the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.]

We analyze determinants of secondary debt market liquidity, identifying conditions under which a large investor can profitably buy stakes from small bondholders and offer unilateral debt relief to a distressed firm. We show that endogenous trading by small bondholders may result in multiple equilibria. Some equilibria entail vanishing liquidity and sharp increases in yields absent changing fundamentals. In turn, anticipation of illiquid equilibria induces firms to eschew public debt financing, since such equilibria create higher bankruptcy costs and debt illiquidity discounts. The model thus offers a rational micro-foundation for stylized facts commonly attributed to investor sentiment and CFO market timing. Finally, we show that the vulnerability of debt markets to multiple equilibria is highest during downturns, when small bondholders face severe adverse selection. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We develop and empirically test a theory of optimal security design under adverse selection accounting for strategic trading by uninformed investors who will liquidate a security in secondary markets only if their idiosyncratic carrying costs exceed the security's expected trading loss. Such investors demand primary market discounts equaling expected carrying costs borne plus trading losses incurred. Issuers minimize the total illiquidity discount by splitting cash-flow into tranched debt claims with liquidity predicted to increase with seniority, while the optimal number of tranches increases with underlying cash-flow risk. Empirical tests confirm our model predictions.

We establish limitations to the usage of direct revelation mechanisms (DRMs) by corporations seeking decision-relevant information in economies with securities markets. In this environment, posting a DRM increases the informed agent’s outside option: if the agent rejects the DRM, he convinces the market he is uninformed, and he can aggressively trade with low price impact, thereby generating large (off-equilibrium) trading gains. This endogenous outside option may make using a DRM to screen uninformed agents impossible. When screening is possible, solely relying on the market for information is optimal if the increase in outside option is sufficiently large.

As an alternative to the pecking order, we develop a dynamic calibratable model where the firm avoids mispricing via signaling. The model is rich, featuring endogenous invest-ment, debt, default, dividends, equity flotations, and share repurchases. In equilibrium, firms with negative private information have negative leverage, issue equity, and overin-vest. Firms signal positive information by substituting debt for equity. Default costs induce such firms to underinvest. Model simulations reveal that repeated signaling can account for countercyclical leverage, leverage persistence, volatile procylical investment, and correla-tion between size and leverage. The model generates other novel predictions. Investment rates are the key predictor of abnormal announcement returns in simulated data, with lever-age only predicting returns unconditionally. Firms facing asymmetric information actually exhibit higher mean Q ratios and investment rates. (JEL G32) Three decades have passed since Leland and Pyle (1977) and Ross (1977) de-veloped the signaling theory of corporate finance. Although their work has been extended, signaling models remain static and qualitative, making it im-possible for empiricists to assess the theory’s ability to match observed time-

We examine the optimal mixture and priority structure of bank and market debt using a trade-off model in which banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior trade-off between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the trade-off theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The trade-off theory also generates predictions consistent with international evidence. In countries in which the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.