Priority Spreading of Corporate Debt

Priority spreading refers to the practice of firms increasing their reliance on secured and subordinated debt and reducing their reliance on senior debt as their credit quality deteriorates. We argue that priority spreading occurs because security provides creditors with greater protection from dilution from other creditors than do covenants that prioritize payments. Consistent with this argument, we find that secured bank creditors are rarely diluted by junior creditors in distressed restructurings, whereas senior unsecured creditors are frequently diluted, exogenous increases in asset volatility result in greater priority spreading and yields on senior and subordinated bonds converge as asset volatility increases.Received January 22, 2018; editorial decision January 27, 2019 by Editor David Denis. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.