A Model of Endogenous Debt Maturity with Heterogeneous Beliefs

This paper studies optimal debt maturity in an economy with repayment enforcement frictions and investors disagree about repayment probabilities. The optimal debt maturity choice is a mix of long- and short-term debt securities. Spreading risky debt claims on cash flows over time allows debt to be priced by investors most willing to hold risk at each point in time, thereby increasing investment and output. By contrast, a single maturity, either all long- or short-term, will be priced by investors less willing to hold risk, which reduces investment and output. The model provides a novel explanation for the stylized fact that large and mature companies almost always issue debt with multiple maturities rather than a single maturity, and is broadly consistent with empirical debt maturity results. Lastly, we show that non-financial covenants that prevent debt dilution only serve as substitutes for short-term debt and do not affect real outcomes as they do not allow the firm to create additional collateral against which to borrow