The Impact of In-Substance Defeasance on Bondholder and Shareholder Wealth





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    • Johnson is from the Department of Finance, Northern Illinois University. Pari is from Sanford Bernstein and Company. Rosenthal is from the Department of Finance, Bentley College. An earlier version of this paper was presented at the 1986 FMA meeting. Subsequent revisions and results remain the sole responsibility of Johnson and Pari. This research was supported, in part, by a grant from the College of Business, Northern Illinois University. The authors are grateful to Chet Ragavan of the Fixed Income Research Group at Merrill Lynch Capital Markets for providing the bond data, to Pamela Peterson for her helpful comments on earlier drafts of the paper, and especially to David Mayers, the co-editor, for his invaluable assistance.


This paper hypothesizes and tests the argument that a defeasance transaction initiates a wealth transfer from stockholders to bondholders. Our empirical tests provide compelling evidence of bondholder gains, but no support for shareholder losses when a firm defeases debt. We speculate that the insignificance of the loss to shareholders is primarily due to the size disparity between the value of defeased debt and the market value of outstanding equity, since the suggested economic merits of defeasance appear unfounded. Although we cannot prove an agency motivation for defeasance, we find a very high correlation between compensation tied to earnings and defeasing debt at a book gain.