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The maturity of debt issues and predictable variation in bond returns

How corporations should manage financial policy to minimize the cost of capital is a question of great theoretical and practical interest. In efficient, integrated, and otherwise perfect capital markets, Modigliani and Miller (1958) and Stiglitz (1974) show that financial policy cannot reduce the cost of capital. Their key insight is that in such idealized markets, the costs of different forms of capital do not vary independently, so there is never any gain to substituting between debt and equity, for example, or between short and long-term debt.

Nonetheless, there is considerable evidence that equity financing is tied to stock return predictability. Firms tend to issue equity when the equity premium is low, and when their idiosyncratic returns are low. They tend to repurchase equity when idiosyncratic returns are high. These patterns are interesting because they are not straight forward implications of the Modigliani-Miller view or its standard extensions. One prominent explanation for these patterns is that firms are timing an inefficient or segmented capital market, and another is that optimal capital structure and rational expected returns vary together over time. It is difficult to distinguish between these explanations, and the truth may involve both.

In this paper, we ask whether time series variation in the maturity of debt issues is tied to predictability in excess long-term bond returns. Relative to the literature on equity financing patterns, and relative to the actual importance of debt financing in the U.S. economy, the literature on debt financing patterns is surprisingly undeveloped. We find strong evidence that firms tend to borrow long-term when subsequent long-term bond returns are predictably low.

Then we examine whether this pattern is more consistent with debt market timing or with an explanation that involves time-varying optimal debt maturity and rational variation in expected bond returns.

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The maturity of debt issues and predictable variation in bond returns