Performance-Sensitive Debt
Summary
Debt whose interest rate depends on the borrower's performance leads to earlier default and lower equity value than fixed-rate debt of the same value, so the trade-off theory cannot explain it. It works instead as an inexpensive screening device, consistent with the pecking-order theory: firms that choose performance-sensitive loans are more likely to see their credit ratings improve. The paper also derives closed-form prices for step-up bonds and linear performance-sensitive debt.
Abstract
This paper studies performance-sensitive debt (PSD), the class of debt obligations whose interest payments depend on some measure of the borrower's performance. We demonstrate that the existence of PSD obligations cannot be explained by the trade-off theory of capital structure, as PSD leads to earlier default and lower equity value compared to fixed-rate debt of the same market value. We show that, consistent with the pecking order theory, PSD can be used as an inexpensive screening device, and we find empirically that firms choosing PSD loans are more likely to improve their credit ratings than firms choosing fixed-interest loans. We also develop a method to value PSD obligations allowing for general payment profiles and obtain closed-form pricing formulas for step-up bonds and linear PSD.
How to cite
Manso, Gustavo, Bruno Strulovici, and Alexei Tchistyi (2010). Performance-Sensitive Debt. Review of Financial Studies 23, 1819–1854.
@article{manso2010performancesensitive,
author = {Manso, Gustavo and Strulovici, Bruno and Tchistyi, Alexei},
title = {Performance-Sensitive Debt},
journal = {Review of Financial Studies},
volume = {23},
number = {5},
pages = {1819–1854},
year = {2010},
doi = {10.1093/rfs/hhq005}
}