Leverage Choice and Credit Spreads when Managers Risk Shift




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    • Murray Carlson is from the Sauder School of Business at the University of British Columbia; Ali Lazrak is from the Sauder School of Business at the University of British Columbia and HEC Paris. We thank seminar participants at Carnegie Mellon University, Connor, Clark, and Lunn Investment Management Ltd., HEC Lausanne, HEC Paris, Northwestern University, the Stockholm School of Economics, the University of British Columbia, the University of Calgary, the University of Colorado at Boulder, the University of Illinois at Urbana Champaign, the 2005 Northern Finance Association Meetings, the 2006 Society for Economic Dynamics, the 2007 American Finance Association Meetings, the 2008 French Finance Association Meetings, the 2009 European Financial Association Meetings, as well as two anonymous referees, the Associate Editor, Ulf Axelson, Harjoat Bhamra, Ivar Ekeland, Adlai Fisher, Thierry Foucault, Lorenzo Garlappi, Ron Giammarino, Robert Goldstein, Rick Green, Cam Harvey (the Editor), Ulrich Hege, Rob Heinkel, Tim Johnson, Marcin Kacperczyk, Erwan Morellec, Hernan Ortiz-Molina, Michael Roberts, Jean-Charles Rochet, Dion Roseman, Neal Stoughton, Ilya Strebulaev (AFA discussant), Per Strömberg, Suresh Sundaresan, Michael Troege (FFA discussant), Fernando Zapatero, Josef Zechner (EFA discussant), Jaime Zender, and Song Zhongzhi for helpful comments. We are grateful to Markit Group Limited for providing us with credit default swap rate data and to Maryam Rastegar and Sandy Tanaka for their administrative help in acquiring these data. Financial support from the Social Sciences and Humanities Research Council of Canada (grant #410-2006-1345) is gratefully acknowledged. An Internet Appendix for this article is available online in the “Supplements and Datasets” section, containing supplementary results and supporting material, at http://www.afajof.org/supplements.asp.


We model the debt and asset risk choice of a manager with performance-insensitive pay (cash) and performance-sensitive pay (stock) to theoretically link compensation structure, leverage, and credit spreads. The model predicts that optimal leverage trades off the tax benefit of debt against the utility cost of ex-post asset substitution and that credit spreads are increasing in the ratio of cash-to-stock. Using a large cross-section of U.S.-based corporate credit default swaps (CDS) covering 2001 to 2006, we find a positive association between cash-to-stock and CDS rates, and between cash-to-stock and leverage ratios.