Optimal Time-Consistent Debt Policies

70 Pages Posted: 4 Jun 2020

See all articles by Andrey Malenko

Andrey Malenko

University of Michigan, Stephen M. Ross School of Business; Centre for Economic Policy Research (CEPR)

Anton Tsoy

University of Toronto - Department of Economics

Date Written: April 29, 2020


We study time-consistent debt policies in a trade-off model of debt in which the firm can freely issue new debt and repurchase existing debt. A debt policy is time-consistent if in any state equityholders prefer to follow it rather than to deviate from it but lose credibility in sustaining debt discipline in the future. In a class of policies, the optimal time-consistent debt policy consists of an interest coverage ratio (ICR) target and two regions for the ICR: the stable and the distress regions. In the stable region, the firm actively manages liabilities to the ICR target by issuing/repurchasing debt. A sufficiently large negative shock to cash flows pushes the firm into the distress region, where it abandons the target and waits until either cash flows recover or further negative shocks trigger bankruptcy. Credit spreads are sensitive to cash flow shocks in the distress region but not in the stable region. The optimal policy captures realistic features of debt dynamics, such as active debt management in both directions, interior optimal debt maturity, and dynamics of “fallen angels.”

Keywords: Capital Structure, Tradeoff Theory, Target Leverage, Time-Consistency, Reputation, Debt Maturity, Credit Spreads

JEL Classification: G32, C73

Suggested Citation

Malenko, Andrey and Tsoy, Anton, Optimal Time-Consistent Debt Policies (April 29, 2020). Available at SSRN: https://ssrn.com/abstract=3588163 or http://dx.doi.org/10.2139/ssrn.3588163

Andrey Malenko

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Centre for Economic Policy Research (CEPR) ( email )

United Kingdom

Anton Tsoy (Contact Author)

University of Toronto - Department of Economics ( email )

150 St. George Street
Toronto, Ontario M5S3G7

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