Rollover Risk and Credit Risk - Faculty

jofi˙1721 jofi2009v2.cls (1994/07/13 v1.2u Standard LaTeX document class) December 26, 2011 15:7 JOFI jofi˙1721 Dispatch: December 26, 2011 CE: AFL Journal MSP No. No. of pages: 39 PE: Beetna 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 THE JOURNAL OF FINANCE • VOL. LXVII, NO. 2 • APRIL 2012 Rollover Risk and Credit Risk ZHIGUO HE and WEI XIONG ∗ ABSTRACT Our model shows that deterioration in debt market liquidity leads to an increase in not only liquidity premium of

corporate bonds but also credit risk. The latter effect originates from firms’ debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt, equity holders bear the losses while maturingdebtholdersarepaidinfull.Thisconflictleadsthefirmtodefaultatahigher fundamental threshold. Our model demonstrates an intricate interaction between liquidity premium and default premium and highlights the role of short-term debt in exacerbating rollover risk. THE YIELD SPREAD OF a firm’s bond relative to the risk-free interest rate directly determines the firm’s debt financing cost, and is often referred to as its credit spread. It is widely recognized that the credit spread reflects not only a default premium determined by the firm’s credit risk but also a liquidity premium due to illiquidity of the secondary debt market (e.g., Longstaff, Mithal, and Neis (2005), and Chen, Lesmond, and Wei (2007)). However, academics and policy makers tend to treat both the default premium and the liquidity premium as independent, and thus ignore interactions between them. The financial crisis of 2007 to 2008 demonstrates the importance of such an interaction— deterioration in debt market liquidity caused severe financing difficulties for many financial firms, which in turn exacerbated their credit risk. In this paper, we develop a theoretical model to analyze the interaction between debt market liquidity and credit risk through so-called rollover risk: when debt market liquidity deteriorates, firms face rollover losses from issuing new bonds to replace maturing bonds. To avoid default, equity holders need to bear the rollover losses, while maturing debt holders are paid in full. This ∗ He is with the University of Chicago, and Xiong is with Princeton University and NBER. An earlier draft of this paper was circulated under the title “Liquidity and Short-term Debt Crises.” We thank Franklin Allen, Jennie Bai, Long Chen, Douglas Diamond, James Dow, Jennifer Huang, Erwan Morellec, Martin Oehmke, Raghu Rajan, Andrew Robinson, Alp Simsek, Hong Kee Sul, S. Viswanathan, Xing Zhou, and seminar participants at Arizona State University, Bank of Portugal Conference on Financial Intermediation, Boston University, Federal Reserve Bank of NewYork, Indiana University, NBER Market Microstructure Meeting, NYU Five Star Conference, 3rd Paul Woolley Conference on Capital Market Dysfunctionality at London School of Economics, Rutgers University, Swiss Finance Institute, Temple University, Washington University, 2010 Western Finance Association Meetings, University of British Columbia, University of California- Berkeley, University of Chicago, University of Oxford, and University of Wisconsin at Madison for helpful comments. We are especially...

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