Capital Structure under Changing Uncertainty

We explain the puzzle of falling firm leverage during the period of decreasing aggregate volatility from 1970 – 2010 with a simultaneous increase in firm level volatility and varying degrees of firm access to public debt markets. By incorporating friction between public and private debt, a structural model where firms make financing policy decisions in presence of uncertainty can explain a significant amount of these puzzling trends. The model results are consistent with the trend that the declining firm leverage is driven by unrated firms. This finding relates to the established trends of increasing idiosyncratic volatility and decreasing macroeconomic volatility. Firms without access to public debt markets have to insure themselves against increasingly volatile idiosyncratic shocks through conservative financing decisions. The model and the empirical results demonstrate that for firms with access to public debt markets, the cost of financing is more closely connected with macroeconomic conditions.