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Signaling, financial constraints, and performance-sensitive debt

Subject

Finance

Publishing details

Working Paper

Authors / Editors

Begley T

Publication Year

2013

Abstract

This paper examines how good borrowers use the design of performance sensitive debt contracts to alleviate financial constraints. I show that borrowers use a convex pricing grid (i.e., a contract where the increase in the loan spread following a decline in performance exceeds the decrease in the spread following a performance improvement) to signal their unobservable creditworthiness and receive better bank loan terms. I find that constrained firms that use convex pricing grids receive loans that are 21-28% larger with a spread that is 31-37 basis points lower than observationally similar borrowers that use fixed spread loans. Consistent with the notion that a costly signal should positively correlate with future financial health, I find that constrained borrowers that use a loan with a convex pricing grid are one third less likely to experience financial distress during the term of their loans.

Keywords

Performance sensitive debt; Signaling; Security design; Financial contracting; Financial constraints

Series

Working Paper

Available on ECCH

No


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