Recent work in corporate finance has suggested that strategic debt-service by equity-holders works to lower debt values and raise yield spreads substantially. We show that this is not quite correct. With optimal cash management, defaults occassioned by deliberate underperformance (strategic defaults) and those forced by inadequate cash (liquidity defaults) work as substitutes: allowing for strategic debt-service leads to a decline in the equilibrium likelihood of liquidity defaults. In some cases, this decline is sufficiently sharp that equilibrium debt values actually increase and yield spreads decline. We provide an intuitive explanation for these results in terms of an interaction of optionalities.
All Science Journal Classification (ASJC) codes
- Economics and Econometrics