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Posted on March 28th, 2013, by

The article Executive Compensation and the Maturity Structure of Corporate Debt by Paul Brockman, Xiumin Martin and Emre Unlu is devoted to the analysis of managerial compensation, the related risk-seeking behaviour of managers and the role of short-term debt in mitigating agency costs of debt which are related to the sensitivities of the CEO portfolios. The authors suppose that companies with high level of managerial risk can use the maturity structure of debt for mitigating agency costs of debt (related to managerial compensation). The authors analyzed previous research and identified two forces affecting the risk-seeking behaviour of managers, which are sensitivities of the executive portfolio to stock prices and stock return volatility.

There are two hypotheses stated in the paper. The first hypothesis (H1) links the proportion of the short-term debt and the sensitivity of managerial portfolios to stock return volatility and stock prices. This hypothesis consists of two sub-hypotheses: H1a: the proportion of short-term debt is negatively related to the sensitivity of the CEO’s portfolio to stock prices (delta) and H1b: The proportion of short-term debt is positively related to the sensitivity of the CEO’s portfolio to stock return volatility (vega) (Brockman & Martin & Unlu, 2010). The second hypothesis (H2) links stock prices and stock volatility to the cost of debt, and is formulated as follows: The proportion of short-term debt reduces the positive (negative) relation between vega (delta) and the cost of debt (Brockman & Martin & Unlu, 2010).

Both sub-hypotheses H1a and H1b appeared to be true. Extraction of archival data based on the sample which included 6,825 firm-year observations and 1,312 unique firms was performed for a 14-year period, from 1992 to 2005. CEO compensation data were taken from S&P ExecuComp database, financial accounting data were extracted from COMPUSTAT annual files, and information on stock return was obtained from CRSP monthly files. The authors used different definitions of short-term debt and estimated sensitivity of the options using the method of Core and Guay (Brockman & Martin & Unlu, 2010). Analysis of the relations between the portfolio sensitivity and the proportion of the long-term debt was performed using a number of econometric techniques. In all cases, positive relationship between short-term funds and high vega for incentives was witnessed, and negative relationship between short-term funds and high delta for the incentive packages. The same results were obtained for a sample including new debt issues.

In order to prove the second hypothesis, the authors have studied the relationships between corporate bond yields, CEO incentive packages and short-term debt. The sample data for this hypothesis were taken from the MFIS database (publicly traded bonds) and Thomson’s Datastream (daily bond yields). The sample for this hypothesis includes 114 companies, 266 bond issues and 268,400 daily bond observations, covering the years from 1994 to 2005. Using the generalized method of moments (nonlinear for this hypothesis) and incremental teting for the new debt issues, the authors have shown that short-term maturity debt increases in vega, but decreases in delta (Brockman & Martin & Unlu, 2010). It appeared that credit yield premiums for high vega and low delta CEO incentive packages were significantly lower than for high delta and low vega packages. In other words, companies with risk-seeking managerial portfolios are likely to borrow at short-term maturities (Brockman & Martin & Unlu, 2010). Thus, the second hypothesis was also proven.

The results of this study are important for the analysis of debt maturity, since the authors have identified two key determinants of debt maturity (deltas and vegas). Creditors can use the findings of Brockman, Martin and Unlu (2010) to analyze the connections between CEO compensation packages, agency costs of debt and risk-seeking behaviour. Finally, the results obtained by the authors show the influence of the proportion of the short-term debt on mitigating agency costs of debt.

Brockman, P. & Martin, X. & Unlu, E. (2010). Executive Compensation and the Maturity Structure of Corporate Debt. The Journal of Finance, 65 (3), 1123-1161.

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