Journal of Banking & Finance 29 (2005) 15851609 www.elsevier.

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The impact of junior debt issuance on senior unsecured debts risk premiums
Scott C. Linn *, Duane R. Stock
Division of Finance, Michael F. Price College of Business, University of Oklahoma, 205A Adams Hall, Norman, OK 73019, USA Received 28 November 2003; accepted 9 June 2004

Abstract Numerous studies have examined the impact of security issuance upon the value of preexisting debt and equity but the focus has largely been on changes in equity value. We examine changes in senior unsecured debt risk premiums that accompany new junior debt issues. Additionally, we test several hypotheses regarding the potential impacts of junior debt issues. Extant theory suggests senior debt value may be threatened under certain conditions by the issuance of junior debt. Our results indicate that when junior debt replaces bank debt, senior default risk premiums experience abnormal declines. The result is broadly consistent with the elevation of the senior unsecured debt by way of the elimination of a separate and more senior class of debt claimants. In contrast, we also nd that larger junior bond issues are associated with abnormal increases in senior risk premiums, broadly consistent with issue size being correlated with negative information about rm cash ows. We nd strong evidence of interaction eects. For example, replacement of bank debt results in greater changes in default risk premiums the larger the issue size. We also nd lower credit ratings magnify other eects. For example, if the junior debt issued matures before the outstanding senior unsecured bond, senior risk premiums experience abnormal increases for lower rated debt. 2004 Elsevier B.V. All rights reserved.
JEL classication: G30; G32 Keywords: Junior debt; Security issuance

Corresponding author. Tel.: +1 405 325 3444/5591; fax: +1 405 325 7688/1957. E-mail address: slinn@ou.edu (S.C. Linn).

0378-4266/$ - see front matter 2004 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankn.2004.06.030

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1. Introduction Senior unsecured and junior long-term corporate bonds are an important part of the U.S. nancial system. Fama and French (1999) report that book value of longterm debt was 3035% of total capital for U.S. corporations between 1972 and 1994. Fabozzi (2000) reports there are over 10,000 dierent issuers of corporate debt in the United States and that individuals and institutions hold corporate debt securities worth over $1.4 trillion in their portfolios. Theory as well as empirical evidence, suggests that security issuances of any type should be of concern to all who hold claims on a rms cash ows (Smith, 1986; Masulis, 1988; Harris and Raviv, 1990; Eckbo and Masulis, 1995; Speiss and Aeck-Graves, 1999). Prior empirical research has, however, largely focused on the eects of security issuance on equity values. Our study is the rst to examine the eects of issuance of one class of debt on another class of debt in other than unusual circumstances. 1 Specically, we focus on the issuance of new junior debt and the impact on the default risk premiums of the existing senior unsecured debt of the issuer. We nd evidence of signicant eects on the senior unsecured debt default risk premiums of junior debt issuers, and that these eects are consistent with several theoretical hypotheses advanced in the literature. For instance, abnormal increases in unsecured senior default risk premiums are associated with larger junior issue sizes, consistent with issue size revealing adverse information about cash ows. Yet, if the junior issue replaces bank debt, senior unsecured default risk premiums fall, consistent with a potential redistribution eect arising from one class of debt being elevated in standing as a consequence of the elimination of another higher class. Numerous authors have investigated the impact of debt issuance on equity values. Eckbo (1986) nds little evidence of any impact of debt issuance on equity values. Chaplinsky and Hansen (1993) nd that the impact of debt issuance on equity value is negative in some circumstances. Speiss and Aeck-Graves (1999) document longterm negative abnormal stock returns following debt issuance. 2 Likewise, several authors have examined senior debt value changes associated with extreme events involving nancing and investment activities such as bankruptcy, leveraged buy-

Unusual circumstances would include for instance leveraged buy-outs or mergers. Several other studies have examined the impact of straight debt issues on equity values and generally nd either no signicant impact upon the common stock prices of the issuers or a small negative eect. These studies also nd no evidence that equity price reactions are systematically related to the quality ratings of the bonds issued, to the size of the issue, or to how the proceeds of the issue are to be used. James (1987) nds no signicant relationship between the abnormal stock returns of the issuer and the maturity of the debt issued. However, in contrast, Tang and Singer (1993) examine a sample of nonsubordinated debt oerings as well as a sample of subordinated oerings; they nd nonsubordinated debt oers are associated with positive abnormal stock returns while subordinated oers are associated with signicantly negative abnormal returns. Also see Smith (1986), Dann and Mikkelson (1984), Mikkelson and Partch (1986), Eckbo (1986), Hansen and Crutchley (1990), Bayless and Chaplinsky (1991) and Shyam-Sunder (1991) for related studies. Two studies that have examined the eects of changes in debt obligations on bond prices are Kim et al. (1977) and Malitz (1989). For an excellent review of debt nancing choice, see Masulis (1988).
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outs, and mergers; but relatively little is known about how more routine nancing and investment decisions aect senior debt value. 3 Senior unsecured creditors are known to suer most from violations of absolute priority rules and to bear the largest cost in reorganization (Weiss, 1990; Fabozzi et al., 1993). During 2002, for instance, senior unsecured bondholders recovered only 32% in bankruptcies compared to the 1980s average of 46%. 4 The potential valuation eects on the senior unsecured debt resulting from a junior debt issue are implicitly a function of the fact that such senior debt suers most during nancial distress and bankruptcy. These circumstances along with the volume of debt outstanding make the implications of junior debt issuance for senior unsecured debt value one of great interest from an academic standpoint of understanding the determinants of any valuation eects observed and how these eects correlate with received theory. We study a sample of junior bond issues sold by companies that had publicly traded senior bonds outstanding for which data on default risk premiums were available. We specically focus on the dierence between the actual default risk premiums of the senior bonds at the time the junior issue is announced and the default risk premium that would have otherwise been expected, computed using a benchmark yield from the Lehman Brothers Bond Yield Indices. We examine the empirical validity of several extant hypotheses concerning the impact of junior debt issuance on senior unsecured debt default risk premiums. First, the protection aorded to the senior unsecured debt may be enhanced whenever the proceeds of a junior issue are used for new investment, potentially providing an additional asset cushion for the senior unsecured debt. 5 Corporate actions that reduce the likelihood of default by, for instance, increasing the asset base for a class
3 For research on bankruptcy, see Warner (1977), Franks and Torous (1994), Betker (1995), Eberhart and Sweeney (1992), Altman and Eberhart (1994), Eberhart et al. (1990), and John (1993). For research on leveraged buy-outs, see Warga and Welch (1993), Lehn and Poulsen (1988), Marais et al. (1989), Asquith and Wizman (1990), Cook et al. (1992), and Crabbe (1991). For research on mergers, see Dennis and McConnell (1986). 4 See Recoveries Fall as Bankruptcies Rise in the Wall Street Journal, December 13, 2002. Mounting evidence indicates the protection promised by the APR is more illusion than fact. Warner (1977), Weiss (1990), Eberhart et al. (1990), and Betker (1995) all document violations of APR. Altman (1991) documents write-downs in defaulted senior unsecured and senior unsecured subordinated debt of 39.5% and 47.7% for a sample of defaulted issues from the period 19851991. Franks and Torous (1994) nd mean write down for senior unsecured debt equal to 53% for a sample of Chapter 11 reorganizations from the period 19831990. Malitz (1994) documents a trend towards less protection for bondholders in terms of fewer protective covenants in bond indentures. At another level, the so-called coordination problem arises when there are multiple creditors, each of which can take actions to foreclose. The problem arises when a rm that is expected to have the ability to cover its debts at maturity faces a current cash ow shortage. While it would be optimal for all the creditors to coordinate and not foreclose, acting in their own self-interest and without the benet of coordination they will choose to foreclose. Such expected behavior makes the debt more risky ex ante (Morris and Shin, 2001). Conicts amongst bondholder classes can cause delays in the resolution of bankruptcy proceedings (Gilson et al., 1990). 5 A typical feature of risky-debt valuation models is that default risk depends upon the likelihood of asset value being less than debt value. Black and Scholes (1973) and Merton (1974) present the original work in the area. Recent contributions to this literature include Leland (1994), Leland and Toft (1996), and Longsta and Schwartz (1995). Bohn (2000) presents an excellent survey of the literature on structural form models. For an excellent example of a reduced form model, see Due and Singleton (1999).

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of creditors, may enhance those claims resulting in a lower default risk premium. We nd no evidence that this eect is present for our sample of junior issues. Second, there may be enhancements in senior unsecured debt when the use of the junior issue proceeds elevates the standing of the existing senior unsecured debt claims. Specically, if the proceeds are used to replace bank debt the result is elimination of a more senior class of debt claims. However, if junior debt replaces bank debt it may result in less bank monitoring of the issuers credit quality. Less monitoring could lead to an increase in default risk and an increase in the default risk premium. Our results are consistent with the former hypothesis that senior unsecured claimants benet from the elimination of a more senior class of debt claimants. Third, there may be valuation eects that arise from deterioration in the eective priority of the senior unsecured claims when the rm issues junior debt. This can occur when the junior debt matures before the issuers senior unsecured debt (Ingersoll, 1987). We nd that in cases where the senior unsecured debt tends to be a lower credit grade and the new junior debt is scheduled to mature before the senior, those senior bonds experience abnormal increases in their default risk premiums. Fourth, the credit quality of the rm, represented by the credit rating of the senior unsecured debt, may also have an impact on abnormal changes in the default risk premium. If the senior debt is of relatively low quality, the junior issuance may raise more serious concerns about the ability of the rm to service all debt and thus raise the default risk premium on the senior. Additionally, the relative credit quality of the senior debt could interact with other factors to enlarge the impact of other factors. We nd abnormal increases in the senior unsecured default risk premiums are positively related to the seniors credit quality. We also nd that other eects are magnied when the senior debt is of lower credit quality. Fifth, new junior debt issues may reveal information about the prospects or value of the issuing rm. New information may result in market participants revising their beliefs about changes in the cash ows available to service the senior unsecured debt as suggested by Miller and Rock (1985) and, hence, result in changes in the default risk premium. Alternatively, debt claims might be issued to avoid implied losses in equity value from selling equity claims at prices below true intrinsic value. Such behavior would be consistent with the presence of asymmetric information between the management team and the market regarding the value of the issuers assets in place (Myers and Majluf, 1984). Our results indicate abnormal increases in the default risk premiums of the senior unsecured debt are positively and signicantly related to the size of the junior issue.

2. The sample and the data examined 2.1. Sample selection We identied corporations that issued junior/subordinated debt during the period 19721990 and also had senior unsecured bonds outstanding at the time of the junior/subordinated debts issuance. Records of the Securities Data Corporation, issues

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of the Investment Dealers Digest, the Wall Street Journal Index, and Moodys Bond Record were the source of this information. We identied the date on which it had been announced that the junior bonds would be issued using the Wall Street Journal Index, Prentice Hall Legal and Financial Services, Securities Data Corporation, Securities and Exchange Commission les, and Disclosure Inc. When an announcement date prior to the registration ling date could not be identied, the ling date was considered the rst announcement. The Wall Street Journal Index was used to identify any issuing companies with signicant news in the announcement month and these companies were eliminated. Junior issue events were then included in the nal sample if prices and yields on the senior unsecured bonds of the issuer could be identied for the announcement month in Moodys Bond Record. We dene senior unsecured debt to include unsecured bonds classied as nonsubordinated debentures or notes, and/or debt instruments specically labeled senior. The sample of senior unsecured bonds contains only xed-rate, nonconvertible, interest-bearing debt. Further, the nal sample includes only actively traded senior unsecured bonds in an attempt to maximize the validity of the observed prices and yields. In this context, senior unsecured bond quotes had to be available for each of the ve months before the junior issue, the month of junior issuance, and each of the ve months after the junior issuance. Finally, we required clear information on how the proceeds of the junior issue were to be used. These constraints resulted in a nal sample of 63 junior debt issues sold between 1972 and 1990, by 36 dierent issuers. All the senior unsecured bonds in the sample were listed on the NYSE at the time of the junior debt announcement. Some issuers had more than one senior unsecured issue outstanding at the junior announcement date. The 36 issuing rms had a total of 125 senior unsecured issues outstanding at the junior announcement date. The mean number of senior unsecured bonds per issuer was equal to 1.98, and the median was 2. 2.2. Characteristics of the sample We obtained characteristics of the senior unsecured bonds, the junior bonds and the issuers in the sample from Moodys Bond Record, Moodys Manuals and the registration statements led with the Securities and Exchange Commission for the junior debt issues. These measures are based upon book values as of the end of the scal year prior to the junior issue announcement. In 27 cases the issuers had publicly traded equity at the time they announced their plans to issue junior debt. We construct an approximate measure of total rm value when an issuers equity was not publicly traded by adding to the book value of assets an estimate of the present value of the interest tax shield on the rms debt. This adjustment, of course, yields only an approximation of the value of a levered rm as dened by Modigliani and Miller (1958) and Fama and Miller (1972). 6 We label the new variable the
MacKie-Mason (1990) and Graham (1996) both present convincing empirical evidence that the use of debt by US corporations is positively related to the marginal tax rate. The evidence presented in Graham and Harvey (2001) suggests companies consider the benets of the tax shield when setting the debt level.
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adjusted total assets of the issuer. We examined the current nancial condition of each issuer and the degree of stability in the issuers debt rating. None of the issuers in the sample were at or near nancial distress, so we feel that assuming the debt tax shield of the issuer will continue is reasonable. Also, there were no bond rating changes for the issuers over the course of our sample period. We estimate the present value of the interest tax shield by multiplying the marginal corporate tax rate at the time of the juniors issuance announcement by the book value of the issuers debt at the prior scal year-end. 7 When the issuer did have publicly traded equity, we computed adjusted total assets as the sum of the total market value of equity at the end of the year prior to the announcement plus the book values of debt and preferred stock. Panel A of Table 1 presents descriptive statistics for the issuers in the sample. The mean (median) adjusted total asset value of the issuers was $23,911.7 ($4606.6) million. The correlation between adjusted total assets and the book value of total assets for the sample rms is 99%. Variables constructed using adjusted total assets as we dene this number, or, in contrast, variables constructed by using the book value of assets, lead to similar inferences in tests of the hypotheses discussed earlier. 8 We measure issuer leverage ratios as total liabilities to adjusted total assets at the year-end prior to the announcement. The mean ratio of total liabilities to adjusted total assets for the sample rms was 67.6% and the median value was 62.8%. We also collected information on the book value of subordinated debt outstanding for each issuer in order to gain some perspective on the extent to which these rms had used such debt prior to the issue represented in the sample. Panel A of Table 1 presents the fraction that subordinated debt represented of total adjusted assets. Only three cases occurred in which the issuer did not have subordinated debt outstanding at the time they announced plans for a junior issue. Subordinated debt made up on average 23.6% of adjusted total assets for the sample rms which had subordinated debt outstanding and the median was 17.4%. Nonsubordinated debt averaged 26.5% of adjusted total assets. Panel B of Table 1 presents descriptive details about the junior debt issues. The mean (median) issue size is $114.6 (100.0) million. The mean (median) issue size relative to the total adjusted assets of the issuer measured at the end of the year prior to the announcement is 2.7% (1.6%). The mean (median) issue size relative to total liabilities is equal to 12.2% (2.2%). Panel C presents details about dierences between the maturities of the debt. The mean (median) maturity for the new junior debt is

7 Dening the marginal corporate tax rate and how to compute it are issues which have not been totally resolved in the literature (see Wilkie and Limberg, 1993; Scholes and Wolfson, 1992). Proposed estimates have included the eective tax rate equal to the tax bill divided by pretax income, the statutory tax rate, and the statutory tax rate adjusted for tax subsidies received by the rm. We opt for the statutory federal rate as an approximation of the mean marginal tax rate for the rm over time. Our calculation implicitly assumes the companies involved will roll over the debt in place. Bowman (1980) has shown that the market value of debt is highly correlated with the book value of debt. See also Sweeney and Winters (1997). 8 We also computed the correlation between what we call adjusted total assets and the sum of the book value of debt, the book value of preferred stock, and the market value of equity for only those cases in which the equity was publicly traded. The correlation is 99%.

S.C. Linn, D.R. Stock / Journal of Banking & Finance 29 (2005) 15851609 Table 1 Summary statistics for the 36 issuers of 63 junior debt issues in the nal sample Mean Panel A: Issuer characteristics Total book value of assets Adjusted total assetsa Total liabilities/adjusted total assets (%) Total subordinated debt/adjusted total assets (%)b Total nonsubordinated debt/adjusted total assets (%) Panel B: New junior issue characteristics Issue size Issue size/adjusted total assets (%) Issue size/total liabilities (%) Coupon on junior issue (%) Panel C: Maturity dierences Maturity of junior issue (years) Remaining maturity of senior unsecured (years) at time of junior issue announcement $21,948.8 $23,911.7 67.6 23.6 26.5 $114.6 2.7 12.2 9.8 11.67 13.29 Median $4013.9 $4606.6 62.8 17.4 20.9 $100.0 1.6 2.2 9.3 10.00 12.77

1591

Std. deviation $45,848.2 $47,328.0 17.0 18.4 21.1 $61.6 4.4 59.5 2.1 6.82 7.21

These statistics are for the junior bonds issued and for the corresponding senior unsecured bonds of the issuers (all $ in millions)c. a See Section 2.2 for computation of adjusted total assets. b Only includes those cases (N = 60) in which the issuer had subordinated debt outstanding at the scal year-end prior to the junior issue announcements. c We found 63 junior bond issues where the issuing rm had senior unsecured bonds outstanding which were actively traded at the time of junior issuance. The total number of senior unsecured bonds outstanding (with active markets) is 125. This table describes relevant statistics for the issuing rms. Data sources include Moodys Bond Record, Moodys Manuals and registration statements led with the Securities and Exchange Commission. All accounting data is measured as of the year-end prior to the announcement of plans to issue junior debt. We dene total liabilities as total assets less book value of total equity.

11.67 (10) years. The corresponding mean (median) time to maturity for the senior unsecured issues as of the month in which the plan to issue junior debt was announced is 13.29 (12.77) years. In 36 cases (57%), the junior issue matured before the associated mean time to maturity of the senior unsecured issues. In nine cases the issuer had multiple senior unsecured bonds outstanding where at least one of the senior unsecured bonds matured after the junior bonds and at least one matured before. Later, we examine a rened sample in which only the senior unsecured bonds that matured after the junior bonds are included for these nine cases. We identied how the proceeds of each junior issue were to be used from several sources including Moodys Manuals, records of Securities Data Corporation, and the issue prospectuses and registration statements obtained from Disclosure, Inc. The types of usage include investing in new assets (investment), repaying bank debt, repaying long-term debt, and repaying commercial paper. In some cases the issuer planned to use the proceeds for multiple purposes. Uses of the junior bond issue proceeds are described in Table 2. The proceeds of 18 of the junior issues were used only to increase assets. Separately, in 11 cases the proceeds were used only to repay bank

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Table 2 Uses of junior bond issue proceeds for the nal sample of 63a Listed uses (and symbol for regression variable) Increase assets only (INV) Increase assets and repay bank debt (INV + REPBANKDEBT) Increase assets and repay long-term debt Increase assets and repay bank debt and repay long-term debt Increase assets and repay bank debt, repay long-term debt, and repay commercial paper Increase assets and repay commercial paper (INV + REPCOMLPAPR) Repay bank debt only (REPBANKDEBT) Repay bank debt and repay long-term debt Repay bank debt, repay long-term debt and repay commercial paper Repay long-term debt only (REPLTDT) Repay long-term debt and repay commercial paper Repay only commercial paper Repay bank debt and repay commercial paper Number of cases 18 16 1 0 0 7 11 0 0 6 0 1 3

a Sources of information include Moodys Manuals, records of Securities Data Corporation and the junior issue prospectuses and registration statements.

debt. In 16 cases the issuer indicated that the proceeds were to be used for both new investment as well as the repayment of bank debt. The remaining cases involved mixtures of several uses including the replacement of long-term debt. The frequencies of other cases, besides those already mentioned, were typically very few in number, making statistical tests for signicance unreliable. For example, there is only one case where the uses were listed as investing in new assets and also repaying longterm debt. The sample includes a broad cross-section of industries as shown in Table 3.

Table 3 Industry membership of the nal sample of junior bond issuersa Aircraft products Automotive products Amusement Energy services Engineering Financials Gambling Home building Medical products and equipment Real estate development Specialty chemicals Vehicle rental Vehicle tires, rubber, plastics Sources of information included Moodys Manuals, records of Securities Data Corporation, and the junior issue prospectuses and registration statements. There are 36 issuers of junior debt represented in the nal sample of 63 junior debt issues.
a

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2.3. Default risk premiums 2.3.1. Data sources We compute a residual default risk premium (RDRP) for each senior unsecured bond in the sample for the month the associated junior issue is rst announced. The residual is the dierence between the actual month-end default risk premium and our estimate (explained below) of the premium that would otherwise have been expected had no issue announcement been made. We then examine potential determinants of the cross-sectional variation in the residual dierences for the sample as a whole. The data set contains residuals computed using yields based upon quotes or transaction prices on the senior unsecured bonds in the sample taken directly from issues of Moodys Bond Record. The quote data can be presented in the form of a bid, an ask, or both bid and ask prices (yields) may be presented, in which case we employ the mean of the bid and ask. We use only quotes or actual transaction prices, never matrix prices. Market transaction prices will generally be based upon odd-lot trades. Warga (1991) shows pricing portfolios of bonds with market (transaction) prices leads to results generally consistent with pricing based upon dealer quotes on the same bonds and concludes the use of month-end transaction prices gives results consistent with those obtained using month-end dealer quotes. We use month-end yield data in our investigation. The sample mean (median) yields for the senior unsecured bonds are 10.78 (10.06). 2.3.2. Residual default risk premiums We dene the default risk premium (DRP) for senior unsecured corporate bond i at time t as the dierence between its yield-to-maturity (ytm) at t and the yield-tomaturity on an equal maturity U.S. Treasury government (g) bond at the same date. Specically, the default premium is equal to DRPi;t ytmc;i;t ytmg;t 1

where subscripts c, i, t refer to corporate bond i at time t. We estimate the expected end-of-month default risk premium for each senior unsecured bond in the sample for the announcement month by using the monthend yield indices produced by Lehman Brothers for corporate debt. 9 Lehman Brothers constructs two time to maturity classes, intermediate and long-term, within each of eight rating classes. We begin by identifying the time to maturity, Ti, and rating, Ri, for each senior unsecured bond i. We then identify the Lehman Brothers rating class index that matches the senior unsecured bonds rating. Next we interpolate between the two Lehman Brothers time to maturity indices for the rating class to generate a benchmark yield with the same time to maturity as the sample bond. The interpolated yield corresponding to this time to maturity is used as the benchmark expected yield for the given bond with time to maturity Ti and rating Ri in
9 These indices include only publicly issued, xed-rate, nonconvertible investment grade, dollar denominated, SEC registered corporate debt.

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the month of the announcement. As both the benchmark yield and the yield on the senior unsecured bond are eectively based upon the same time to maturity, the same government bond yield is used to compute the default spreads. The method for computing residual default risk spreads employed here neutralizes the eect of (default) risk free interest rate changes because it is measured at the same time as the senior unsecured bonds yield. The following equation summarizes the calculation of the residual default risk premium (RDRP) where ytmL,t is the benchmark yield computed from the Lehman Brothers Indices: RDRPc;i;t ytmc;i;t ytmg;t ytmL;t ytmg;t ytmc;i;t ytmL;t : 2

Some issuers in the sample had multiple senior unsecured bonds outstanding in the announcement month, and the yields on more than one senior unsecured bond for a given issuer were available in several of these cases. The yield spreads for the senior unsecured bonds of a single issuer are likely to exhibit cross-sectional correlation. The residual default risk premiums for such bonds are, therefore, also likely to be correlated. Econometrically, it is inappropriate to treat data points that are correlated as if they are independent observations as this would tend to bias coecient test statistics in any cross-sectional regression. In order to avoid this problem we aggregate observations by issuer. 10 Specically, suppose issuer i had two senior unsecured bonds outstanding at the time the junior issue announcement was made. In this case we average the RDRPs for the issuers senior unsecured bonds to obtain a single observation for the issuer. We will explore the cross-sectional determinants of the residual default risk premiums. In the next section, we suggest that several nonmutually exclusive eects may inuence any particular senior unsecured bond residual default risk premium at the time of a junior debt announcement. Further, we do not predict these eects to have the same directional impact. Consistent with the presence of opposing crosssectional eects, we observe no particular patterns in the mean residual default risk premium in the months surrounding the announcement month (see Appendix A).

3. Factors aecting residual default risk premiums Several potential explanations exist for the cross-sectional variation in residual default risk premiums of the senior unsecured debt claims. The safety of the senior unsecured debt may improve if proceeds of a junior issue are used to increase assets (invest). In such a case, the asset base supporting existing senior unsecured debt claims will be greater in the event of nancial distress and the default risk premium is thus predicted to decline. We examine this proposition in our cross-sectional tests by introducing a variable we label INV. The variable INV equals 1 (18 cases, Table 2) when the proceeds of the junior issue were used only for new investment; otherwise, INV is 0.

10

We are grateful to Arthur Warga for originally having pointed out this issue to us.

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There are eleven cases in which the proceeds of the issue are only used to repay bank debt (Table 2). These cases are interesting because they allow an opportunity to test alternative hypotheses regarding rearrangement of capital structure and bank monitoring. The rearrangement of capital structure is important because debt with a higher priority (bank debt) than senior unsecured debt is replaced with debt having a lower priority (junior bonds) than the senior unsecured debt. Welch (1997) nds that over 99% of bank loans are senior to public debt. When the proceeds of a junior issue are used to retire bank debt, this action elevates the relative status of the senior unsecured debt predicting an improvement in credit quality and reduction in default risk of the senior unsecured debt. If this hypothesis is true, the default risk premium of the senior unsecured debt should decline. In those cases where the only use is the repayment of bank debt, the dummy variable REPBANKDEBT is assigned the value 1 and is otherwise assigned the value 0. We also investigate the combined eect of using the proceeds of an issue to repay bank debt as well as for new investment. We assign the dummy variable INV + REPBANKDEBT the value 1 (16 cases) when the proceeds of an issue are to be used for both new investment and for the repayment of bank debt; otherwise the variable takes the value 0. Alternatively, replacing bank debt can potentially increase the RDRP as theory has suggested banks are potentially the best monitors of credit quality. More specifically, cross-monitoring occurs when monitoring by one type of creditor (a bank) reduces the need for other creditors to monitor the rm. Campbell and Kracaw (1980), Diamond (1984, 1991), Ramakrishnan and Thakor (1984), and Fama (1985) have argued banks have a cost advantage in monitoring loans. For example, Fama (1985) maintains banks have access to inside information whereas bondholders use only public information. Among others, James (1987) and Mikkelson and Partch (1986) nd the announcement of bank credit line changes conveys good news to the stock market, consistent with this view. Datta et al. (1999) nd that rms making initial bond oerings enjoy lower interest costs if bank debt is present on the balance sheet. In our case, replacing bank debt with junior debt suggests the rm may be monitored less by banks; consequently, monitoring of outstanding securities such as senior unsecured debt could fall, resulting in an increase in default risk. Our model specication will identify whether the rearrangement of capital structure or a reduction in monitoring dominates. The safety of the senior unsecured debt may also be inuenced by the timing of the maturity of the junior compared to the unsecured senior. Ingersoll (1987) has suggested the payos to senior unsecured debt can be threatened if the new junior debt matures before the outstanding senior unsecured debt, eectively making the junior debt senior. Assume a setting in which violations of absolute priority in bankruptcy do not occur. Also assume the rm has senior unsecured debt outstanding as well as junior debt outstanding. If the senior unsecured debt matures rst and assets exceed the face value of the senior unsecured debt, then these bondholders receive the face value of their claims and are satised. On the other hand, if the junior debt matures rst, the net amount left may be insucient to cover the senior unsecured claims. In the extreme case, the junior debt claims are paid rst even if it bankrupts the rm, leaving no assets to satisfy the senior unsecured debt claims.

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Many senior unsecured bond indentures include a covenant requiring the payment of the senior unsecured debt in full upon failure to meet payment of the prior maturing junior obligations. There could well be some states of nature, however, in which funds will be sucient to cover the junior debt claims, but not the senior unsecured claims, exposing the senior unsecured debt to additional risk. The covenant just described would, therefore, not protect the senior unsecured bondholders in such a situation. However, the senior unsecured debt could still be protected because, if paying the junior debt bankrupted the rm within a certain period of time, the payment could be considered a preference; and the junior bondholders would be forced to return the funds to the rm. The senior unsecured debt holders, in principle, would not be any the worse o, and the impact of the junior issue would be negligible. 11 We compute the dierence between the remaining time to maturity of the senior unsecured bonds for an issuer (at the time of junior issuance) and the time to maturity of the junior debt issued. The mean of these dierences (senior maturity less junior maturity) is then computed. In those cases (N = 27) where there is just one senior unsecured bond for the rm, we are obviously working with a single data point. If the dierence is positive, we assume the majority of the senior unsecured bonds matured after the junior bond, and we assign the variable MATD a value of 1. If the mean is negative, a value of zero is assigned. For 36 cases in the sample MATD takes the value 1. After discussing the results based upon the above denition of MATD, we present evidence on the sensitivity of our conclusions to the manner in which MATD is dened. Information on the extent to which a rms senior unsecured bonds mature before or after a new junior issue would be available to the market at the time the issue announcement is made. The credit rating of the rm may aect the RDRP. Consider a rm whose senior unsecured bonds have the highest rating. In this case a junior bond issuance will likely not materially aect the default risk of the senior unsecured debt. In contrast, consider senior unsecured bonds with considerably lower ratings. Here a junior issuance could more likely lead to a signicant increase in default risk. To represent this potential eect, we include the variable SENRATAVE to represent the mean rating for an issuers senior unsecured bonds. Bonds with a Aaa rating were assigned a value of 1, those rated Aa were assigned 2, those rated A were assigned 3, and so on. We also test for interaction of rating with relative maturity. That is, junior debt that matures before senior unsecured may be a greater threat to the senior unsecured if the senior bond rating is low. (We also interact rating with issue size as discussed below.) The last eect is related to information revealed about the future prospects of the rm by the choice to issue junior debt. Miller and Rock (1985) suggest the size of a new security issue can reveal information about the issuers current and future operating cash ows. Changes in the operating cash ows of an issuer have a direct bearing on the ability of the rm to service its existing debt. Prior to the declaration that a

11

We thank a referee for this observation.

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new junior issue will be sold, the markets beliefs about the future cash ows of the issuer are summarized by the pre-issue cash ow distribution. If Miller and Rocks conjectures are correct, the announcement should cause the market to revise its beliefs about the future cash ows of the rm downward. The probability that the issuer will be able to service the senior unsecured debt would thus decline. If, as Miller and Rocks analysis suggests, larger issues reveal more adverse information about operating cash ows, then we would expect a greater reduction in expected cash ow the larger the junior issue, and hence a positive relation between the RDRP and the size of the junior issue. An alternative view is that debt is issued, instead of equity, to avoid losses from selling equity claims at below their true value, a prediction consistent with the Myers and Majluf (1984) model. In this case, the size of a debt issue would therefore not necessarily reveal any incremental information of use in the valuation of an issuers existing debt claims. Our examination makes use of the variable Ln(ISSUE), where Ln() denotes the natural logarithm and ISSUE equals the dollar value of the new junior issue divided by the adjusted total assets of the issuer. In this way, we capture the relative importance of issue size. We also explore the possibility Ln(ISSUE) interacts with INV, REPBANKDEBT, and INV + REPBANKDEBT to generate a joint eect on default risk spreads. That is, INV, REPBANKDEBT, and INV + REPBANKDEBT may be more pronounced for larger issues. For example, a junior bond issue used to pay o bank debt could be more important in elevating the relative priority of the senior unsecured debt the larger the junior issue. Also, the information eect of issue size may be stronger for cases where the senior unsecured debt has a low rating. We present supplemental results in which we test these hypotheses.

4. Cross-sectional regression results 4.1. Basic regression results Table 4 presents the results of regressing the residual default risk premiums (RDRP) on the variables INV, REPBANKDEBT, INV + REPANKDEBT, MATD, SENRATAVE, and Ln(ISSUE). We add two more variables in order to control for other eects. First, we control for time eects by accounting for a major institutional change. The Bankruptcy Act of 1978 and its subsequent amendments constituted a potentially important structural change with implications for the valuation of debt claims. We dene a dummy variable BANKDUM78 and assign it the value 1 when a junior issue was announced in any year following 1977. In 53 of the issue cases, the variable BANKDUM78 takes the value 1. Also, we include the variable REPLTDT to represent cases where the junior debt replaced long-term debt. Unfortunately, our sources do not reveal the relative priority of the long-term debt replaced. If the new junior debt replaces other junior debt, the impact would be neutral upon existing senior unsecured debt. On the other hand, if the new junior debt replaces senior unsecured debt, the relative priority of remaining senior unsecured

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Table 4 Regression estimates of the relation between the residual default risk premia (RDRP) and the variables, INV, REPBANKDEBT, INV + REPBANKDEBT, MATD, SENRATAVE, Ln(ISSUE), and BANKDUM78, REPLTDTa (p-values in parentheses) Column Intercept INV REPBANKDEBT INV + REPBANKDEBT MATD SENRATAVE Ln(ISSUE) BANKDUM78 REPLTDT Sample size F, (p-value) Adjusted-R2 JB (residuals), (p-value)
a

(1) 1.4464 (0.001) 0.0293 (0.899) 0.6784 (0.012) 0.8582 (0.000) 0.2129 (0.175) 0.1625 (0.024) 0.3332 (0.136) 0.2563 (0.415) 63 5.351 (0.000) 0.3294 0.664 (0.717)

(2) 0.3037 (0.364) 0.1002 (0.655) 0.6754 (0.013) 0.950 (0.000) 0.2577 (0.113) 0.1600 (0.032) 0.3600 (0.114) 0.2735 (0.386) 63 5.228 (0.000) 0.3231 2.282 (0.319)

(3) 0.9697 (0.124) 0.0112 (0.961) 0.7066 (0.009) 0.9130 (0.000) 0.2512 (0.120) 0.0933 (0.302) 0.1095 (0.211) 0.3700 (0.103) 0.2222 (0.482) 63 4.825 (0.000) 0.3304 0.566 (0.753)

The default risk premium for a bond is equal to its yield minus the yield on a US Treasury bond with the same time to maturity. The residual default risk premium (RDRP) is the default risk premium for a senior unsecured bond observed at the end of the month in which a plan to issue junior debt is announced, minus a benchmark default risk premium on bonds of similar risk and time to maturity as the senior unsecured bond. The variable INV equals 1 when the proceeds of the issue are used only for new investment and 0 otherwise. REPBANKLTDT takes the value 1 when the proceeds are used to replace long-term debt and 0 otherwise. INV + REPBANKDEBT represents cases where the usage was to both increase assets and replace bank debt. The variable MATD describes the relative maturity of the senior and junior debt, which is detailed in the text. SENRATAVE is the mean rating of the senior debt outstanding. The variable Ln(ISSUE) equals the natural log of the dollar amount of the oer divided by the adjusted total assets of the issuer. BANKDUM78 is a dummy representing cases before and after changes in the bankruptcy act. The variable REPLTDT takes the value 1 when the proceeds are used to repay bank debt and 0 otherwise. The p-values shown in parentheses are for the test that the relevant coecient is equal to zero. The test employed accounts for heteroscedasticy through the White (1980) adjustment to the standard errors of the estimates when heteroscedasticity is present. The JB statistic is the JarqueBera test for normality applied to the estimated residuals of the model. Low values of the JB statistic (high values of the associated p-values) lead to the conclusion that the null hypothesis of normally distributed residuals cannot be rejected. The nal sample contains 63 junior debt issues sold between 1972 and 1990. There are a total of 125 senior unsecured bonds associated with the junior debt issuers for which data are available. There are 36 issuers represented in the sample.

debt could improve. To control for any such eects, we include REPLTDT. Tests of the null hypothesis that the estimated coecients are equal to zero are computed

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using White standard errors whenever homoscedasticity is rejected using the White (1980) test. The variable ISSUE, which equals the dollar value of the new junior issue divided by the adjusted total assets of the issuer, is skewed. Therefore, we present regressions using its natural logarithm, Ln(ISSUE). We cannot reject the null hypothesis that Ln(ISSUE) is normally distributed at conventional levels. The JarqueBera test statistic for the hypothesis equals 1.50 with a p-value of 0.47, indicating the null of normality is clearly not rejected at conventional levels. 12 The tables reporting the regression results also report the JarqueBera test statistic for the residuals of each model estimated. Based upon these residual tests, we never reject the null hypothesis that the residuals are normally distributed at conventional levels. Table 4 contains the results of three regressions. In the regression reported in Column 1, the estimated coecient for INV is never signicantly dierent from zero at conventional levels. The coecient is negative in two of the regressions. Thus, the evidence provides only very weak support for the hypothesis that when proceeds of a junior issue are to be used only for new investment, the senior unsecured bonds benet. The estimated coecients on the dummy variable REPBANKDEBT are always negative. Further, these coecients are always statistically dierent from zero. This result is consistent with the hypothesis that the elimination of bank debt results in a promotion of the senior unsecured bonds to a relatively higher eective level of seniority. This eect is apparently stronger than the eect suggested by the (reduced) monitoring hypothesis, which suggests a positive sign. In those cases where the proceeds of an issue are to be used both to repay bank debt as well as for new investment, the senior unsecured bonds clearly benet. The estimated coecients for the variable INV + REPBANKDEBT are negative and are signicantly dierent from zero. The point estimate of the coecient on INV + REPBANKDEBT tends to be more negative than the point estimate of the coecient for REPBANKDEBT. We tested the hypothesis that the coecient for the variable INV + REPBANKDEBT was equal to the coecient for the variable

The JarqueBera statistic is used to test the hypothesis that a given set of data is drawn from a normal distribution. The test statistic measures the dierence of the skewness and kurtosis of the series with those from the normal distribution. The statistic is computed as:   N k 2 1 S K 32 ; JB 6 4 where S is the skewness, K is the kurtosis, and k represents the number of estimated parameters used to create the series (Jarque and Bera, 1987). The JarqueBera statistic is distributed as with 2 degrees of freedom under the null hypothesis of a normal distribution. We also could not reject the null hypothesis of normality for the variable RDRP (JB = 3.202 and p = 0.201). The tables reporting the regression results also report the JarqueBera test statistic for the residuals of each model estimated. Based upon these residual tests, we never reject the null hypothesis that the residuals are normally distributed at conventional levels.

12

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REPBANKDEBT using a Wald test and found they were not signicantly dierent. 13 We conclude the dominant eect is clearly due to the repayment of bank debt and not to investment in new assets. The results indicate while the estimates of the coecients for MATD are positive, they are not signicantly dierent from zero at conventional levels. Thus the Table 4 results are consistent with the idea that early payment of the junior would be regarded as a preference and there is no signicant impact of relative maturity on RDRP. The estimated coecients on the variable Ln(ISSUE) are positive and statistically signicant. The analysis of Miller and Rock (1985) suggests larger security issues will reveal more adverse information about the issuers current and future operating cash ows, and the results for the variable Ln(ISSUE) are consistent with this hypothesis. 14 A major revision to the US Federal Bankruptcy Code was implemented in 1978. The change resulted from the successful lobbying of large creditors and bankruptcy lawyers to increase their negotiation powers relative to small creditors and non-management equity holders. This could reduce the default risk premium, assuming the bondholders are large creditors. While the estimated coecient on the dummy factor, BANKDUM78, is negative, we cannot conclude the coecient is signicantly dierent from zero. The lack of signicance in these specications could be due to the large number of changes (1980 and 1984) to the bankruptcy act subsequent to 1978. The coecient on the last variable, REPLTDT, representing the use of junior debt to replace long-term debt, is never signicant. The rst regression (column 1) of Table 4 did not control for the rating of the senior unsecured debt, SENRATAVE, as regressions, including both SENRATAVE and Ln(ISSUE) resulted in a lack of signicance for both. This is likely due to a high correlation between these measures (0.617) resulting in a collinearity problem. Thus, we omit Ln(ISSUE) in Column 2 of Table 4 but include SENRATAVE which results in the coecient on SENRATAVE being positive and signicant as predicted. Otherwise, the results of column 2 are very similar to Column 1. Column 3 shows the results if both SENRATAVE and Ln(ISSUE) are included; SENRATAVE and Ln(Issue) both become insignicant, and the other results are very similar to those shown in columns 1 and 2. The JarqueBera test of the null hypothesis the residuals are drawn from a normal distribution never rejects the null for the regressions presented in Table 4. The coecients representing the eects, INV, REPBANKDEBT, SENRATAVE, and Ln(ISSUE), have mixed signs in Table 4. The eects of any particular junior bond issue may therefore exhibit a mix of these specic eects.

The results for the Wald test that the coecient on INV + REPBANKDEBT is equal to REPBANKDEBT in the regression reported are: F = 0.456, p = 0.502. 14 Results were also generated using a variable measured as follows: the junior issue amount divided by total book value of assets, where book value of assets is from the year-end prior to the announcement. The results using this new variable were qualitatively the same as those found in tables reported in the text.

13

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4.2. Issue size and senior credit rating interaction The results presented in Table 4 do not account for interaction between dierent explanatory variables. We expect a greater impact for all proceeds usages as issue size increases. For example, if the issue is small, the impact of a junior issue replacing bank debt will be small in the context of the senior unsecured debt moving up the priority ladder. A larger issue will potentially improve the priority of senior unsecured debt to a greater degree. We also introduce senior unsecured bond rating as an interaction variable. Issue size may be more important for senior unsecured bonds with lower credit ratings. The negative information suggested by Miller and Rocks theory may be more important if a rm is closer to nancial distress (as suggested by a low rating) than for rms with much stronger credit ratings. Similar logic applies to the maturity variable MATD: if the junior issue matures before the senior unsecured, the threat to the senior unsecured debt may be greater for lower credit quality rms. Table 5 presents the results of including these interaction considerations. We begin with a discussion of the results in Column 1. Similar to the results in Table 4, we nd no eect when bond proceeds are used for new investment (INV), while there is a negative and signicant eect when proceeds are used to repay bank loans (REPBANKDEBT). Variables interacting usage and Ln(ISSUE) also have signicantly negative coecients, except for INV * Ln(ISSUE) and REPLTDT * Ln(ISSUE). Interaction signicance strongly suggests that relative issue size does have an important interactive eect. The coecient on Ln(ISSUE) by itself was not signicant in a separate regression (not shown here) that included the interaction eects; again, this is likely due to strong colinearity with bond rating. As in Table 4, the residual default risk premium increases with lower credit ratings (SENRATAVE). Variables interacting credit rating with Ln(ISSUE) and relative maturity have positive coecients. Credit rating interacting with Ln(ISSUE) is positive and signicant, while rating and maturity interaction is marginally signicant (6% level). The bankruptcy dummy is now almost signicant at the 5% level. The second column of Table 5 includes the results of a regression where we dene the maturity variable dierently. That is, only senior unsecured bonds maturing after the junior bond matures are included for those cases when the issuer had multiple senior bonds outstanding and some mature before and some after the junior bond. For example, we consider a rm that has three senior unsecured bonds outstanding where one matures before the junior and two others mature after the junior. Then of the two that mature after the junior, one matures 4 years later than the junior, and the other matures 6 years later than the junior, giving a mean of 5. (As mentioned above, there are nine cases where some of the senior unsecured bonds of the issuer mature after and some before the new junior issue.) The new variable (MATNEW) is assigned the value 1 for each of these nine cases and otherwise takes the same value as MATD. We estimate regressions using the new variable MATNEW in place of MATD. In these new regressions, data included for the nine cases mentioned above are modied so only data corresponding to the senior unsecured bonds maturing after the junior bonds for the nine cases are included. The data for the remaining

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Table 5 Regression estimates of the relation between the residual default risk premia (RDRP) and the variables INV, REPBANKDEBT, INV + REPBANKDEBT, INV * Ln(ISSUE), (INV + REPBANKDEBT) * Ln(ISSUE), SENRATAVE, SENRATAVE * Ln(ISSUE), SENRATAVE * MATD, SENRATAVE * MATNEW, BANKDUM78, REPLTDT, and REPLTDT * Ln(ISSSUE)a (p-values in parentheses) Column Intercept INV REPBANKDEBT INV + REPBANKDEBT INV * Ln(ISSUE) (INV + REPBANKDEBT) * Ln(ISSUE) REPBANKDEBT * Ln(ISSUE) SENRATAVE SENRATAVE * Ln(ISSUE) SENRATAVE * MATD SENRATAVE * MATNEW BANKDUM78 REPLTDT REPLTDT * Ln(ISSSUE) Sample size F, (p-value) Adjusted-R2 JB (residuals), (p-value) (1) 0.4727 (0.096) 0.6443 (0.238) 3.9449 (0.002) 3.8894 (0.001) 0.1328 (0.235) 0.7022 (0.001) 0.8448 (0.001) 0.5052 (0.000) 0.0964 (0.001) 0.0762 (0.060) 0.3767 (0.052) 63 7.474 (0.000) 0.510 0.173 (0.917) (2) 0.4405 (0.126) 0.5782 (0.296) 3.9741 (0.000) 3.8881 (0.000) 0.1178 (0.298) 0.7302 (0.001) 0.8390 (0.002) 0.5075 (0.000) 0.0983 (0.001) 0.0090 (0.031) 0.3652 (0.063) 63 7.072 (0.000) 0.494 0.159 (0.923) (3) 0.5355 (0.082) 0.4101 (0.560) 3.6986 (0.001) 3.6301 (0.000) 0.0809 (0.565) 0.6379 (0.008) 0.7815 (0.006) 0.4250 (0.022) 0.0783 (0.052) 0.0791 (0.061) 0.4191 (0.046) 0.6733 (0.478) 0.1948 (0.432) 63 6.118 (0.000) 0.497 0.027 (0.986) (4) 0.4929 (0.114) 0.3125 (0.661) 3.6870 (0.001) 3.6062 (0.001) 0.0611 (0.668) 0.6614 (0.007) 0.7717 (0.007) 0.4204 (0.026) 0.0789 (0.054) 0.0092 (0.033) 0.4009 (0.060) 0.7047 (0.465) 0.1938 (0.443) 63 5.784 (0.000) 0.481 0.049 (0.975)

a The default risk premium for a bond is equal to its yield minus the yield on a US Treasury bond with the same time to maturity. The residual default risk premium (RDRP) is the default risk premium for a senior unsecured bond observed at the end of the month in which a plan to issue junior debt is announced, minus a benchmark default risk premium on bonds of similar risk and time to maturity as the senior unsecured bond. The variable INV equals 1 when the proceeds of the issue are used only for new investment and 0 otherwise. The variable REPBANKDEBT takes the value 1 when the proceeds are used to repay bank debt and 0 otherwise. The variable REPBANKLTDT takes the value 1 when the proceeds are used to replace long-term debt and 0 otherwise. INV + REPBANKDEBT represents cases where the usage was to both increase assets and replace bank debt. The variable MATD describes the relative maturity of the senior and junior debt which is detailed in the text. SENRATAVE is the mean rating of the senior debt outstanding. MATNEW is a variation on maturity described in the text. The variable

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Table 5 (continued) Ln(ISSUE) equals the natural log of the dollar amount of the oer divided by the adjusted total assets of the issuer. BANKDUM78 is a dummy representing cases before and after changes in the bankruptcy act. The variable REPLTDT takes the value 1 when the proceeds are used to repay bank debt and 0 otherwise. The p-values shown in parentheses are for the test that the relevant coecient is equal to zero. The test employed accounts for heteroscedasticy through the White (1980) adjustment to the standard errors of the estimates when heteroscedasticity is present. The JB statistic is the JarqueBera test for normality applied to the estimated residuals of the model. Low values of the JB statistic (high values of the associated p-values) lead to the conclusion that the null hypothesis of normally distributed residuals cannot be rejected. The nal sample contains 63 junior debt issues sold between 1972 and 1990. There are a total of 125 senior unsecured bonds associated with the junior debt issuers for which data are available. There are 36 issuers represented in the sample.

54 cases remain the same. We interact the new variable with the senior unsecured rating and label this interaction variable SENRATAVEMATNEW. This new interactive maturity variable is now more clearly signicant than for the prior maturityinteraction in column 1. The adjusted-R2 for this regression remains quite high as for the others in Table 5. Columns 3 and 4 include the variables REPLTDT and REPLTDT * Ln(ISSSUE). The coecients on these additional variables are not signicant. Also, the other coecients are not qualitatively aected by including the additional variables. It is important to note the adjusted R2 values are considerably higher for the regressions presented in Table 5 compared to the Table 4 results, which means that the additional variables combine with others to explain a considerably higher percentage of the variation in the residual default risk premium. Other models, including a variable in which MATD was interacted with Ln(ISSUE) (not reported here), were also estimated. We could not reject the null that the estimated coecient on this variable was equal to zero. The remaining coecients and inferences were qualitatively the same as those shown in Table 5. Appendix B reports results using MATNEW instead of MATD for the models used to generate Table 4. The results are similar to those presented in Table 4 except that the coecients of MATNEW are marginally more signicant than for MATD. 4.3. Sensitivity tests We tested the sensitivity of the results with respect to numerous factors. First, we tested the robustness of the results by controlling for company size. The size proxies included the book value of total assets and the book value of equity, both measured at the scal year-end prior to the junior issues announcement as well as our above measure dened as adjusted total assets (discussed in Section 2). The estimated coefcients on these rm size variables were never signicantly dierent from zero at conventional levels. Further, the signs and signicance levels for the coecient estimates on other variables were similar to those already presented. Second, we also investigated whether growth in total assets and growth in total earnings contributed to the explanatory power of the models. We computed annual compound growth in total assets and total earnings for each sample company over the three-year period prior to the junior issue announcement. The source of the raw data included Moodys Manuals and the COMPUSTAT les. The estimated coecients on these growth

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variables were never signicantly dierent from zero at conventional levels and the signicance of other variables was very similar to prior results. Third, we also included a dummy variable that takes the value 1 if the issuer used the junior proceeds to repay commercial paper (0 otherwise) as an explanatory variable, but it was never signicant. For brevitys sake, we do not present these results. 15 We also estimated models with various alternative controls for time in place of the dummy variable BANKDUM78. The results were not sensitive to the alternative control variables. 16 Finally, separate tests, not reported here, using bootstrapped standard errors indicate the regression results are robust.

5. Summary and conclusions We examined the eects of the decision to issue new junior debt on the dierence between the actual default risk spreads of the issuers senior unsecured bonds and the spreads which would otherwise have been expected. We sought explanations for the cross-sectional variation in these residual spreads by exploring the validity of several hypotheses concerning the potential changes in relative safety and protection of the senior unsecured debt resulting from the issuance of junior debt. We hypothesized that when the proceeds of a new junior issue are used for investment purposes, eectively increasing assets and the safety of the senior unsecured bonds, the residual default risk spreads on the senior unsecured bonds should fall. Our empirical results do not support this particular hypothesis. We also hypothesized that if the junior debt replaced bank debt, the improvement in priority for the senior unsecured debt could reduce default risk. As an alternative to this hypothesis, the default risk could increase due to a reduction in bank monitoring. The results strongly support the former hypothesis. Next, we hypothesized that senior unsecured debt is more threatened the lower the credit quality of the senior unsecured debt. We nd support for this hypothesis. Also, with respect to the safety of the senior unsecured debt, we hypothesized that when the junior issue matures prior to the senior unsecured debt, the security of the senior unsecured debt is threatened and the default risk spread may increase. We nd the strongest support for this hypothesis in cases including low rated senior unsecured bonds. Our nal hypothesis concerned information revealed by the act of junior issue. We suggest that the larger the size of the junior issue, the more senior unsecured bonds are adversely aected because a larger issue size implies more negative information about future operating cash ows. Our results support this hypothesis. The implications of our cross-sectional results for investors are complex: a junior issue may either increase or decrease the default risk premium on senior unsecured debt depending on characteristics of the junior bonds and the reasons for their issue. Existing senior unsecured default risk could decline if the junior issue is one which
The results are available from the authors upon request. We introduced dummy variables for each of the individual years and, separately, dummy variables for blocks of years.
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replaces bank debt, if the rm has a strong credit rating, and if the size of the junior issue is small relative to the issuers size. On the other hand, default risk will likely increase if the new debt does not replace bank debt, if the rm has a weak credit rating, and if the size of the junior issue is large relative to assets. Mixtures of these characteristics will lead to more complex results. Senior unsecured bondholders should be aware of these eects as a junior bond issue could signicantly reduce or enhance the value of their investment. Acknowledgement We are grateful to two anonymous reviewers, to J. Cotter, L. Ederington, S. Gilson, A. Warga and to participants in the Finance Seminar Series at the University of Oklahoma for their comments on an earlier version of the paper and to G. Willard, R. Gunser, T. Hughes, Le Duong and G. Caton for valuable research assistance. We also thank participants at the Southwest Finance Symposium (Tulsa) for their comments. Both authors gratefully acknowledge research support from the Harold S. Cooksey Estate and the University of Oklahoma and the latter author also thanks the Bank of Oklahoma for research support. The usual caveats apply. Appendix A The mean senior unsecured residual default risk premia for the ve months prior to the announcement of a planned junior bond issue and the announcement montha M-5 Mean residual default risk premium Standard deviation Standard error t for mean = 0 Median t-Values for test that mean in month M (the announcement month) is equal to the mean in each of the previous ve months, assuming unequal variances M-4 M-3 M-2 M-1 M 0.2876 0.7251 0.9136 3.1420 0.2114 0.1235 0.1179 0.2024 0.1627 0.1461 1.1990 0.1540 0.7976 0.1284 0.9068 1.2210 0.1576 0.7483 0.1196 1.0760 1.0620 0.1372 1.4752 0.2984 0.6204 1.0559 0.1363 1.1936 0.1832 0.9161 0.97583 0.12597 1.15990 0.17910 1.22940

a For each month, beginning with ve months (M-5) before announcement, we calculate the mean residual default risk premium. M is the month of announcement. The default risk premium for a bond is equal to its yield minus the yield on a US Treasury bond with the same time to maturity. The residual default risk premium (RDRP) is the default risk premium for a senior unsecured bond observed at the end of the month in which a plan to issue junior debt is announced, minus a benchmark default risk premium on bonds of similar risk and time to maturity as the senior unsecured bond. The nal sample contains 63 junior debt issues sold between 1972 and 1990. There are a total of 125 senior unsecured bonds associated with the junior debt issuers for which data are available. There are 36 issuers represented in the sample.

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Appendix B Regression estimates of the relation between the residual default risk premia (RDRP) and the variables, INV, REPBANKDEBT, INV + REPBANKDEBT, MATNEW, SENRATAVE, Ln(ISSUE), and BANKDUM78, REPLTDTa (pvalues in parentheses) Column Intercept INV REPBANKDEBT INV + REPBANKDEBT MATNEW SENRATAVE Ln(ISSUE) BANKDUM78 REPLTDT Sample size F, p-value Adjusted-R2 JB (residuals), (p-value) (1) 1.4638 (0.001) 0.0246 (0.916) 0.8166 (0.001) 0.6372 (0.020) 0.2673 (0.111) 0.1816 (0.015) 0.3235 (0.153) 0.2699 (0.401) 63 4.936 (0.000) 0.3076 0.515 (0.772) (2) 0.1899 (0.585) 0.1250 (0.589) 0.9225 (0.000) 0.6337 (0.022) 0.3149 (0.074) 0.1787 (0.023) 0.3550 (0.125) 0.2894 (0.370) 63 4.758 (0.000) 0.297 2.762 (0.251) (3) 0.9424 (0.138) 0.0256 (0.914) 0.8837 (0.000) 0.6737 (0.015) 0.3224 (0.065) 0.1041 (0.263) 0.1257 (0.157) 0.3666 (0.112) 0.2254 (0.485) 63 4.500 (0.000) 0.3111 0.718 (0.698)

a The default risk premium for a bond is equal to its yield minus the yield on a US Treasury bond with the same time to maturity. The residual default risk premium (RDRP) is the default risk premium for a senior unsecured bond observed at the end of the month in which a plan to issue junior debt is announced, minus a benchmark default risk premium on bonds of similar risk and time to maturity as the senior unsecured bond. The variable INV equals 1 when the proceeds of the issue are used only for new investment and 0 otherwise. The variable REPBANKDEBT takes the value 1 when the proceeds are used to repay bank debt and 0 otherwise. INV + REPBANKDEBT represents cases where the usage was to both increase assets and replace bank debt. The variable MATNEW is a variable describing the relative maturity of the senior and junior debt, which is described in detail in the text. SENRATAVE is the mean rating of the senior debt outstanding. The variable Ln(ISSUE) equals the natural log of the dollar amount of the oer divided by the adjusted total assets of the issuer. BANKDUM78 is a dummy representing cases before and after changes in the bankruptcy act. REPLTDT represents cases where the junior bond replaces long-term debt. The p-values shown in parentheses are for the test that the relevant coecient is equal to zero. The test employed accounts for heteroscedasticy through the White (1980) adjustment to the

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1607

Appendix B (continued)
standard errors of the estimates when heteroscedasticity is present. The JB statistic is the JarqueBera test for normality applied to the estimated residuals of the model. Low values of the JB statistic (high values of the associated p-values) lead to the conclusion that the null hypothesis of normally distributed residuals cannot be rejected. The nal sample contains 63 junior debt issues sold between 1972 and 1990. There are a total of 125 senior unsecured bonds associated with the junior debt issuers for which data are available. There are 36 issuers represented in the sample.

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