The terms under which firms borrow can be revealing about what they think of their future prospects, according to investigations by Vidhan Goyal and Wei Wang, who looked at instances when firms chose short- or long-term debt maturity and the likelihood that this was guided by their privately-held information.

“Firms with favorable private information prefer short-term debt and those with unfavorable private information prefer long-term debt,” they said.

“This is because a firm with favorable private information about its default risk will seek to benefit from refinancing on favorable terms when their true credit quality is revealed to the market at a later date.

“Conversely, borrowers with unfavorable private information about their future default risk prefer long-term debt because it eliminates uncertainty about future refunding costs or exposure to liquidity risks.”

Goyal and Wang demonstrated this phenomenon by examining a sample of 4,089 debt issues in the U.S. from 1983-2003 and focusing on the default risk of borrowers as measured by two key variables: asset volatility, which relates directly to a firm’s default risk, and distance to default (DTD), which is inversely related to default risk. They also looked at rating migrations following debt issues. Short-term debt was classified as less than three years to debt maturity and long-term debt as greater than seven years.

The results showed short-term debt issuers experienced a significant decline in their default risk, as seen by the fact that their DTD increased and their asset volatility declined following the issue. For example, two years after issue their DTD increased from 6.69 to 7.24, which translated into a 19 per cent decrease in default likelihood. Long-term debt issuers, on the other hand, saw a decline in DTD and an increase in asset volatility. Similar outcomes were also seen in debt migration.

“These differences in default risks for short- and long-term debt issuers are unlikely to be due to differences in firm policies in the period following the debt issue,” the researchers said. “In fact, both short- and long-term issuers exhibit similar changes in leverage, asset tangibility, profitability, variability of operating income, leverage, market-to-book assets ratio, and investments in fixed assets in the two years following the debt issue.”

All of this points to private information at the time of debt issuance being a factor, which was further supported in tests on firms that deviated from the debt maturity they would have been predicted to opt for.

“Small high-growth firms are more likely to borrow short-term debt while large low-growth firms are more likely to borrow long-term debt,” they said. When these firms went the opposite way – for example, large low-growth firms opted for short-term debt and small high-growth ones issued long-term debt – the effects described above were significantly larger.

Overall, the results bolstered the central argument that a borrower’s private information about their default risk is an important determinant of their debt maturity choices.