A Theory of Debt Market Illiquidity and Leverage Cyclicality

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 equilibr...

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Bibliographic Details
Published in:The Review of financial studies 2011-10, Vol.24 (10), p.3369-3400
Main Authors: Hennessy, Christopher A., Zechner, Josef
Format: Article
Language:English
Subjects:
Adverse selection
Bankruptcy
Corporate debt
Costs
Debt
Debt financing
Debt market
Debt relief
Economic theory
Equilibrium
Financial models
Investors
Liquidity
Market equilibrium
Market prices
Market timing
Public debt
Secondary markets
Studies
Yield
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Summary: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.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhr051