What Do Credit Markets Tell Us About the Speed of Leverage Adjustment?

This paper proposes a new methodology to infer investors' expectations about the speed of leverage adjustment implicit in the prices of credit instruments. On average, the credit markets imply a fairly rapid annual speed of adjustment of 26% toward a firm's predicted leverage. The speed varies considerably across partitions formed by the differential implications of the pecking order, market timing, and trade-off theories of capital structure. This finding suggests that investors' expectations are formed in accordance with all three theories. We also show that the addition of firm fixed effects in the predicted leverage model gives noisier estimates of investors' expectations of future leverage, and that a firm's initial leverage is a poor estimate of its future leverage.