Risk Shifting, Debt Governance and Managerial Incentives

This paper studies the impact of debt governance on firms' risk shifting behavior. We construct firm-level debt governance indices using corporate bond indenture provisions, and a market-based risk shifting measure estimated using a contingent-claim framework. We first document that firms with strong debt governance subsequently lower business risk relative to their industry peers, and this relationship mainly exists among firms with high default probability. Further evidence suggests that debt governance plays an important role in mitigating the impact of managerial risk-taking incentives on risk shifting. Higher sensitivity of CEO wealth to stock volatility (Vega) is significantly positively related to risk shifting, but this effect is significantly weakened when strong debt governance is in place. Also, bondholders appear to benefit from the impact of debt governance on risk shifting. Higher Vega is associated with higher credit spreads for bonds under weak debt governance. Under strong debt governance, higher Vega is associated with significantly lower credit spreads.