The wealth impact of new subordinated debt on existing stockholders and senior bondholders : wealth transfer, signalling, and risk-shifting incentives
Most bond indenture provisions have covenants requiring new issues to be equal in priority or subordinated to the existing issues [Smith and Warner (1979)]. This study analyzes the impact on existing stockholders' and bondholders' wealth caused by the issuance of junior debt with maturity shorter than outstanding senior debt. It is shown that such a debt issue results in a wealth transfer from the current stockholders to the outstanding bondholders. The intuition behind this result is that if premature bankruptcy occurs at the junior bond's maturity, total ownership of the firm will pass to the bondholders. Senior bondholders will be entitled to claim the firm's liquidation value first. Therefore, it is in the senior bondholders' interests to have shorter-term junior debt in the firm's capital structure. This may cause early bankruptcy [Black and Cox (1976)]. Because early bankruptcy favors the senior bondholders, there is no reason for them to restrict this type of financing. Furthermore, given the firm value, managers acting in the interests of current stockholders will not issue shorter-term junior debt. However, if firm insiders have private information about the firm's prospects, they may be motivated to issue short-term junior debt. This may signal information. This study examines one possible reason why some firms issue short-term junior debt; information asymmetry between insiders and outsiders. It is shown that a separating signalling equilibrium may obtain. In equilibrium, the superior firm's managers may find it in the stockholders' interest to issue short-term junior debt, and the inferior firm resorts to issuing equity or long-term junior debt. In this model, a wealth transfer from stockholders to existing senior bondholders due to the issuance of short-term junior debt becomes value-preserving signalling cost in a sense that there is no deadweight loss of the firm value. The impact of short-term junior debt on stockholders' risk-shifting incentives is also analyzed. In the context of mean-preserving spread, it is demonstrated that when a firm has outstanding long-term risky senior debt, the issuance of short-term risky junior debt always mitigates the stockholders' risk-shifting incentives. Finally, this study examines, empirically, the stock price effects of straight subordinated debt offerings and investigates the relevance of debt's maturity structure. The evidence is not inconsistent with the signalling hypothesis.