Scooping Up Own Debt On the Cheap: The Effect Of Corporate Bonds Buyback on Firm’s Credit Condition

The paper constructs a structural model to study the effect of corporate bonds buyback on the firm’s credit conditions. The model implies that the firm strategically choose how much debt to buy back and the buyback reduces the firm’s probability of default. In contrast to commonly perceived deleverage channel, the model highlights a novel channel that buying back bonds on the cheap transfers value from bondholders to equity holders and incentivizes the equity holders to choose a much lower assets value to declare default. The lowered default boundary furthermore reduces debt overhang and increases return to equity. The virtuous cycle does not stop until the marginal benefit of bonds buyback equals its marginal cost. The model also implies that when bonds market liquidity dries up, the firm should buy back more bonds, as the shortage of liquidity is independent of the firm’s fundamental but depresses the market price of bonds. The paper also provides empirical evidences for the implications. ∗Department of Economics, University of Illinois. E-mail: [email protected]. An earlier version of this paper was titled “Bonds Buyback, Credit Risk and Liquidity Risk”. I am grateful to my committee members: George Pennacchi (Chair), Timothy Johnson, Heitor Almeida, Dan Bernhardt and Alexei Tchistyi for their help and guidance. I also thank Neil Pearson, Joshua Pollet and Yufeng Wu and Finance seminar participants at University of Illinois for their for valuable comments. All errors remain my own. It is well known that firms have trouble issuing new bonds to raise funding during economic recessions . However, an intriguing fact is that many firms are engaged in bonds buyback at the same time. As noted by the Wall Street Journal during the burst of dot-com bubble (Newswires (2000)): “ It’s not just investors who are bargain-hunting amid the beaten-down sectors of the corporatebond market. Companies themselves are beginning to buy back their own debt at discount prices”