Executive Compensation and the Maturity Structure of Corporate Debt

Abstract

Executive compensation influences managerial risk preferences through executives' portfolio sensitivities to changes in stock prices (delta) and stock return volatility (vega).Large deltas discourage managerial risk-taking, while large vegas encourage risk-taking.Theory suggests that short-maturity debt mitigates agency costs of debt by constraining managerial risk preferences. We posit and find evidence of a negative (positive) relation between CEO portfolio deltas (vegas) and short-maturity debt. We also find that shortmaturity debt mitigates the influence of vega-and delta-related incentives on bond yields.Overall, our empirical evidence shows that short-term debt mitigates agency costs of debt arising from compensation risk. JEL:G30; G32 Keywords: Executive compensation; Agency costs; Debt maturity * Lehigh University, Washington University, and University of Nebraska. The authors thank an anonymous referee and associate editor, the editor (Campbell R. Harvey), and co-editor (John R. Graham) for their suggestions and comments during the revision process. The authors also thank Mary McGarvey, James Schmidt and seminar participants at Washington University, University of Missouri, Texas Christian University, and University of Texas-Dallas for their comments. Forthcoming in THE JOURNAL OF FINANCE 2The use of stock-and option-based executive compensation has increased dramatically during the past few decades. The median exposure of CEO wealth to stock prices tripled between 1980 and 1994(Hall and Liebman (1998), and then doubled again between 1994and 2000 (Bergstresser and Philippon (2006). Such changes in executive compensation have a direct impact on the manager's exposure to risk, thus altering both incentives and behavior. Carpenter (2000) and Lambert, Larcker, and Verrecchia (1991) discuss two effects of compensation on managerial incentives. One effect is caused by the sensitivity of compensation to stock prices (delta). A second effect is caused by the sensitivity of compensation to stock return volatility (vega). The higher the compensation package's sensitivity to stock prices, the weaker will be the manager's appetite for risk (Knopf, Nam, and Thornton (2002)). In contrast, the higher the compensation package's sensitivity to stock return volatility, the stronger will be the manager's appetite for risk (Knopf, Nam, and Thornton (2002), Coles, Daniel, and Naveen (2006)). By altering managerial risk preferences, stock-based compensation also influences third-party (e.g., creditors, suppliers, customers) perceptions of those risk preferences. The primary objective of this study is to investigate the role of short-term debt in reducing agency costs of debt arising from executive incentive contracts. Specifically, we examine the effect of the two portfolio sensitivities on the maturity structure of corporate debt. In addition, we analyze the effect of debt maturity on the relation between portfolio sensitivities and bond yields. The empirical results provide a consistent picture that short-term...

CEO inside debt and corporate debt maturity structure

“…The effects of asset maturity structure and firm leverage on short-maturity debt are significantly negative. These results are generally in line with prior theoretical predictions and empirical evidence in the literature (e.g., Johnson, 2003;Brockman et al, 2010). On the other hand, the coefficients on market-to-book and R&D expenses are positive but insignificant, while those on abnormal earnings and the term structure of interest rates are significant with unexpected signs.…”

“…Datta et al (2005) find that when managers have strong interest alignment with shareholders, they have an incentive to shorten debt maturity and subject themselves to the monitoring of short-term debt. Brockman et al (2010) show that CEO portfolio deltas (vegas) have a positive (negative) effect on debt maturity, which is consistent with creditors understanding the risk incentives induced by option-based compensation and hence adjusting the debt maturity to mitigate those incentives. Our research adds to these studies by providing evidence of a significant and negative relation between CEO inside debt and debt maturity structure.…”

“…To address the concern that this measure is based on an arbitrary cutoff point, in our robustness checks, we consider alternative measures by using the proportions of debt maturing within one, two, and five years. Following previous studies of debt maturity structures (e.g., Johnson, 2003;Datta et al, 2005;Brockman et al, 2010;Custodio et al, 2013;Harford et al, 2014), we control for the following variables in our regressions of short-maturity debt on CEO inside debt holdings: firm size, firm size squared, market-to-book, abnormal earnings, asset maturity structure, asset volatility, firm leverage, research and development (R&D) expenses and its dummy variable, and the term structure of interest rates. We provide detailed definitions of the variables in Table A.1 of Appendix 2.…”

“…To the extent that CEO inside debt reduces firms' exposure to refinancing risk and lowers the cost of debt financing, it incentivizes managers to take on the lower cost, shorter term debt; this choice of debt maturity, in turn, may help reduce investment distortions, improve firm performance, and ultimately increase managers' payoffs. These arguments lead to the following alternative hypothesis: In terms of our dependent variable, we measure short-term debt as the fraction of debt due within three years (Barclay and Smith, 1995;Johnson, 2003;Billett et al, 2007;Brockman et al, 2010;Harford et al, 2014). To address the concern that this measure is based on an arbitrary cutoff point, in our robustness checks, we consider alternative measures by using the proportions of debt maturing within one, two, and five years.…”

Does the Variability of Other Comprehensive Income (OCI) Play a Role in the Determination of Cost of Debt, Capital Structure and Credit Ratings?

“…It is important to note that management may also have an incentive to agree to restrictive covenants because rational creditors will price the loan at a lower value (or higher yield) in the absence of a commitment to restrictive covenants. Prior research shows that debt maturity term and leverage can be simultaneously used to control for lending risk, resulting in reduced agency costs of the debt (Leland and Toft, 1996;Barnea, Haugen, and Senbet, 1980;Rajan and Winton, 1995;Johnson, 2003;Brockman, Martin, and Unlu, 2010). If creditors view increased OCI variability to be new information about the riskiness of the firms' debt, creditors may then demand a shorter maturity structure as OCI increases in volatility.…”