The Debt Trap: Wealth Transfers and Debt-Equity Choices of Junk-Grade Firms

If outstanding debt is risky, issuing equity transfers wealth from equity holders to debt holders. If existing leverage is high and bankruptcy costs are small, this wealth transfer effect outweighs the gains to stockholders from optimizing firm value. Empirically, we find that for investment-grade firms, higher leverage implies a greater likelihood of issuing equity, as expected in a standard tradeoff model. However, consistent with the impact of wealth transfer effects, for junk-grade firms, higher leverage implies a greater likelihood of issuing debt. The analysis implies an additional route through which historical shocks determine firms’ financing choices.