What Can We Learn About Capital Structure from Bond Credit Spreads? by M. Flannery, S. Nikolova and O. Oztekin Discussed by J. Helwege FDIC September 2006

Summary  Looks at two main theories of capital structure to see how they affect credit spreads  If capital structure affects spreads (it does), then credit spreads may provide evidence on which theory of capital structure is closer to the truth empirically  Dataset is firms with both bond prices (sometime in the 1986 to 1998 period) and capital structure data on Compustat Follows Collin-Dufresne, Goldstein and Martin in using changes and in variable list

Motivation  Lot of work on yield spreads these days, with work by Collin- Dufresne and Goldstein pointing out that a target leverage ratio may be an overlooked element of theories such as Merton or Longstaff and Schwartz. Not much done empirically. Eom, Helwege, and Huang (2004) test CDG and 4 other models, finding that CDG, like Longstaff and Schwartz, tends to overpredict spreads on average Huang and Huang (wp) ask how much of the yield spread is due to credit risk by testing several models, including CDG and find that CDG is unable to get the predicted probability of default right (neither are the others)  Lot of work on capital structure, and it’s all messy. Maybe corp bond spreads can shed some light on the issue Maxwell and Stephens (2003) do event study with bonds Note, ignores the work of Baker and Wurgler

Hypothesis testing  Target leverage specification assumes smooth and steady movement toward target Hovakimian, Opler and Titman (2001) suggest possibility of no movement if close to target, and only movement when deviation from target is large Is movement toward target a function of costs, a la Bayless and Chaplinsky (1990)?  Serious critique of Shyam-Sunder and Myers’ approach to testing the pecking order (Chirinko and Singha (2000)) Helwege and Liang (1996) or Frank and Goyal (2003) better but not so easy for this paper. Even Shyam-Sunder and Myers stick with IG

Hypothesis testing  Intro and part of model suggest this is a paper about structural models, but not much about the model relies on the insight that equity is a call option on the assets of the firm Could as easily use the reduced form framework?  CDG have the only structural model that includes target leverage and it has a very specific formulation – it is layered on the framework of Longstaff and Schwartz. Nothing in test is specific to CDG

Empirical work  Conclusion of CDGM is that bonds seem to react more to aggregate market factors and changes in liquidity than to changes in default risk parameters Not clear the profession has accepted that as the final word  Inability to find role for default risk factors a reason to avoid this technique?

Empirical work  Bondholders care about getting repaid which is a function of the probability of default. Default occurs when an obligation is not repaid, not when ST or LT debt is not repaid For capital structure, might want just debt KMV fans like 1/2 LT plus all ST Eom et al uses total liabilities Empirical question, so use them all?

Empirical work  No easy task to forecast financing deficit Still, it is the Achilles heel of the empirical work in this paper Watch for lumpiness in cap ex among junk issuers

Conclusion  Capital structure and corporate bond pricing literature should have a huge intersection, but so far it is minimal  While it is not easy to provide compelling data that richness of the capital structure is the feature missing from bond pricing models, it would be really interesting to know whether that is the case  Likewise, in the endless search for solid evidence on the determinants of capital structure, we might find some good clues by looking at how the bond market prices credit risk  Challenge is to define how these factors interact (a la CDG?) and to reliably identify the parameters in a dataset