In a Crisis, Companies Opt for Shorter-Term Bonds

Companies actively manage their debt-maturity structure by strategically refinancing and rolling over debt. A model by Chicago Booth’s Zhiguo He and Northwestern’s Konstantin Milbradt explains the dynamics behind what many observed in the 2007–10 financial crisis: when times get tough, companies are more likely to take on shorter-term debt.

Say a company holds a lot of long-term bonds that are about to mature. It could shorten its debt-maturity structure by replacing its long-term bonds with short-term ones. Or it could lengthen its structure by refinancing.

Just like a homeowner, a company may refinance when conditions are good and rates are low. But when a company is struggling and conditions are deteriorating, it may pay more for long-term debt and take a rollover loss when refinancing.

To explain the dynamics, the researchers created a model based on a widely used framework developed in the 1990s by University of California, Berkeley’s Hayne Leland. Under that framework, when cash flow drops, companies are more likely to default.

But He and Milbradt argue that a company’s debt-maturity structure is relevant to the decision of whether and when to default. In 2007 and 2008, financial firms shortened their debt maturities as the subprime-mortgage market was worsening. “If default was going to occur in the near term anyway, then bond holders gained significantly by taking possession of the collateral sooner,” write He and Milbradt.

The shorter maturity structure could help a company pretty itself up for a quick sale. It could also cause the company to default sooner, increasing the amount bondholders are able to recover. “The earlier the default, the higher the defaulting cash-flows, the higher the debt recovery value,” the researchers write.

Their model suggests that with worsening economic conditions, companies that already have short debt-maturity structures are likely to shorten them further.