Varun Srinivas - Academia.edu (original) (raw)
Papers by Varun Srinivas
Most structural models of default preclude the firm from altering its capital structure. In pract... more Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean-reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low-leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative-grade debt, consistent with recent empirical findings. CLAIM DILUTION, THE ABILITY OF FIRMS to issue additional debt of equal or greater priority in the future, has been identified by Fama and Miller (1972) and Smith and Warner (1979) as a method by which equity can expropriate wealth from current bondholders. Brick and Fisher (1987) report that prior to 1950 covenants were in place that precluded firms from issuing pari-passu, or equal-priority debt. By 1976, however, such covenants had mostly disappeared. Analyzing 414 long-term public debentures issued during 1960-1992 by industrial firms, Malitz (1994) finds that covenants in place typically allow for a significant amount of equal-priority debt to be issued in the future.1 Further, most indentures even permit a small amount of secured debt to be issued in the future.2 Hence, although many debentures have covenants in place to protect bondholders against major changes in capital structure such as leveraged buyouts, in general, firms with sufficient sol-(the editor), and two anonymous referees for helpful comments. 1 On average, she finds future debt can be issued to a point where the leverage ratio can rise 21.3 percent higher than the leverage ratio that exists at the date of the prior debt's issuance. Here, leverage ratio is defined as the ratio of future funded debt (basically, long-term debt) to consolidated net-tangible assets. 2 See Stulz and Johnson (1985). Limiting future secured debt has been coined a negative pledge. Secured debt is effectively of higher priority than senior unsecured debt, having a significantly higher recovery rate than unsecured debt. See, for example, Franks and Torous (1989) and Altman (1992). 1929
The purpose of this article is to explain the spread between rates on corporate and government bo... more The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds. THE PURPOSE OF THIS ARTICLE is to examine and explain the differences in the rates offered on corporate bonds and those offered on government bonds ~spreads!, and, in particular, to examine whether there is a risk premium in corporate bond spreads and, if so, why it exists. Spreads in rates between corporate and government bonds differ across rating classes and should be positive for each rating class for the following reasons: 1. Expected default loss—some corporate bonds will default and investors require a higher promised payment to compensate for the expected loss from defaults. 2. Tax premium—interest payments on corporate bonds are taxed at the state level whereas interest payments on government bonds are not. 3. Risk premium—The return on corporate bonds is riskier than the return on government bonds, and investors should require a premium for the higher risk. As we will show, this occurs because a large part of the risk on corporate bonds is systematic rather than diversifiable. The only controversial part of the above analyses is the third point. Some authors in their analyses assume that the risk premium is zero in the corporate bond market. 1
Most structural models of default preclude the firm from altering its capital structure. In pract... more Most structural models of default preclude the firm from altering its capital structure. In practice, firms adjust outstanding debt levels in response to changes in firm value, thus generating mean-reverting leverage ratios. We propose a structural model of default with stochastic interest rates that captures this mean reversion. Our model generates credit spreads that are larger for low-leverage firms, and less sensitive to changes in firm value, both of which are more consistent with empirical findings than predictions of extant models. Further, the term structure of credit spreads can be upward sloping for speculative-grade debt, consistent with recent empirical findings. CLAIM DILUTION, THE ABILITY OF FIRMS to issue additional debt of equal or greater priority in the future, has been identified by Fama and Miller (1972) and Smith and Warner (1979) as a method by which equity can expropriate wealth from current bondholders. Brick and Fisher (1987) report that prior to 1950 covenants were in place that precluded firms from issuing pari-passu, or equal-priority debt. By 1976, however, such covenants had mostly disappeared. Analyzing 414 long-term public debentures issued during 1960-1992 by industrial firms, Malitz (1994) finds that covenants in place typically allow for a significant amount of equal-priority debt to be issued in the future.1 Further, most indentures even permit a small amount of secured debt to be issued in the future.2 Hence, although many debentures have covenants in place to protect bondholders against major changes in capital structure such as leveraged buyouts, in general, firms with sufficient sol-(the editor), and two anonymous referees for helpful comments. 1 On average, she finds future debt can be issued to a point where the leverage ratio can rise 21.3 percent higher than the leverage ratio that exists at the date of the prior debt's issuance. Here, leverage ratio is defined as the ratio of future funded debt (basically, long-term debt) to consolidated net-tangible assets. 2 See Stulz and Johnson (1985). Limiting future secured debt has been coined a negative pledge. Secured debt is effectively of higher priority than senior unsecured debt, having a significantly higher recovery rate than unsecured debt. See, for example, Franks and Torous (1989) and Altman (1992). 1929
The purpose of this article is to explain the spread between rates on corporate and government bo... more The purpose of this article is to explain the spread between rates on corporate and government bonds. We show that expected default accounts for a surprisingly small fraction of the premium in corporate rates over treasuries. While state taxes explain a substantial portion of the difference, the remaining portion of the spread is closely related to the factors that we commonly accept as explaining risk premiums for common stocks. Both our time series and cross-sectional tests support the existence of a risk premium on corporate bonds. THE PURPOSE OF THIS ARTICLE is to examine and explain the differences in the rates offered on corporate bonds and those offered on government bonds ~spreads!, and, in particular, to examine whether there is a risk premium in corporate bond spreads and, if so, why it exists. Spreads in rates between corporate and government bonds differ across rating classes and should be positive for each rating class for the following reasons: 1. Expected default loss—some corporate bonds will default and investors require a higher promised payment to compensate for the expected loss from defaults. 2. Tax premium—interest payments on corporate bonds are taxed at the state level whereas interest payments on government bonds are not. 3. Risk premium—The return on corporate bonds is riskier than the return on government bonds, and investors should require a premium for the higher risk. As we will show, this occurs because a large part of the risk on corporate bonds is systematic rather than diversifiable. The only controversial part of the above analyses is the third point. Some authors in their analyses assume that the risk premium is zero in the corporate bond market. 1