Insolvency resolution and the missing high yield bond markets

Finance

Further details

In many countries, costly bankruptcy procedures force insolvent firms to restructure out of court. We develop a model where dispersed bond investors as well as large banks provide credit to firms. Banks have a bargaining advantage out of court, but  convex capital costs.

The model predicts that all firms use bank financing. Among large firms, safer firms always issue bonds (alongside loan financing). Riskier firms only use the bond market when bankruptcy works well (because bondholders dislike out of court negotiations). The model matches empirical patterns: across countries, efficient bankruptcy is associated with more bond issuance by risky, but not by safe, borrowers. We use insolvency reforms as natural experiments to confirm this pattern within  countries.

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