Introduction

This paper provides a theory of how highly levered borrowers with private information about their credit prospects choose the seniority and maturity of their debt. The main result is that when different lenders own the short-term and long-term debt issues, short-term debt will be senior to long-term debt. This result follows from the difficulty of restructuring and renegotiating bonds that are held by the public. I develop the implications of choosing an optimal debt structure for the decisions of banks to make concessions on their loans. Recent empirical evidence on debt concessions by banks is discussed in light of the results.

The debt maturity and priority choice trades off protection of the borrower's control rents against increasing the sensitivity of the borrower's financing costs to new information. Short-term debt provides information sensitivity; this is desired because it benefits a borrower who expects his credit rating to improve. If the borrower cannot repay the debt in full, however, the lender has the right to remove the borrower from control (I term this a liquidation), and shorter-term debt makes this possibility happen sooner. Liquidation has beneficial effects, and ought not be eliminated. Lenders may, however, be too prone to liquidate. Some related papers on the effects of debt structure on control are Aghion and Bolton (1992), Harris and Raviv (1990), Hart and Moore (1989, 1990), Jensen (1989), and Jensen and Meckling (1976). Flannery (1986) examines the effect of debt maturity on information sensitivity.

Lenders might liquidate too often because part of the future returns of the project can be assigned only to the borrower, and not to lenders.