A Theory of Debt Maturity: The Long and Short of Debt Overhang

Abstract

Debt maturity influences debt overhang: the reduced incentive for highly-levered borrowers to make real investments because some value accrues to debt. Reducing maturity can increase or decrease overhang even when shorter-term debt's value depends less on firm value. Future overhang is more volatile for shorter-term debt, making future investment incentives volatile and influencing immediate investment incentives. With immediate investment, shorter-term debt typically imposes lower overhang; longer-term debt can impose less if firm value is more volatile in bad times. For future investments, reduced correlation between the value of assets-in-place and profitability of investment increases the overhang of shorter-term debt.

Taxes, Governance, and Debt Maturity Structure: International Evidence

“…For distressed companies, its impact is insignificant, probably because they are more concerned with their survival than underinvestment and/or signalling. These results suggest that short-term debt mitigates the debt overhang problem, as suggested by Myers (1977), but only in good times, in line with Diamond and He (2014). We find a homogeneous significant effect of firms' fundamental variables, such as size, leverage, and asset maturity across all our specifications, consistent with previous evidence (e.g., Smith and Watts, 1992; Barclay and Smith, 1995;Diamond, 1991).…”

“…Their reliance on predominantly short-term debt exposes them to rollover risk, and reduces the present value of their tax shields, and their growth potentials (e.g., Diamond, 1991). In the presence of agency conflicts between shareholders and debtholders, high leverage results in two additional major costs which exacerbates the underinvestment and asset substitution problems: (i) risk-shifting driven by shareholders' incentive to increase the riskiness of the firm's existing assets, even when this would reduce the value of their firm (Jensen and Meckling, 1976;Warga and Welch, 1993), and (ii) debt overhang which arises when debt is high and risky, shareholders tend to have a disincentive to commit new equity capital to be invested in projects that would make debt safer, even if these projects are value creating (Myers, 1977;Diamond and He, 2014). Short-term debt is expected to mitigate these conflicts as it reduces the managers' and the controlling shareholders' power (Ben-Nasr et al, 2015), because it is less sensitive to risk shifting in the firm's underlying assets (Barnea et al, 1980), and to debt overhang as it matures sooner than the realisation of investment returns (Myers, 1977), compared to long-term debt which amplifies these conflicts when the refinancing risk is high due to rollover losses (Almeida et al, 2011;Li, 2013).…”

“…However, Diamond and He (2014) argue that short-term debt can increase or decrease debt overhang depending on the timing of the investment. More specifically, debt overhang is reduced by short-term debt for assets in place, while it is increased for future investment opportunities, because this impact depends on the extent to which the value of short-term debt is sensitive to the value of the firm.…”

Rollover Risk and Credit Risk

“…This is similar in spirit to the debt overhang problem described by Myers (1977). See Diamond and He (2010) for a recent study that further analyzes the effects of short‐term debt overhang on firms' investment decisions 12…”

The Leverage Ratchet Effect

“…See, for example, He and Xiong () and He and Milbradt (). Diamond and He () also show that short maturity may exacerbate debt overhang.…”