In the standard theory of corporate finance, supply conditions in the credit markets have traditionally not been considered as prominent determinants of the firm's financing decisions and resulting capital structure of the firm. Instead, the theory has been primarily demand-driven: in trade-off theory, firms choose the optimal debt-equity ratio such that the marginal tax benefit of issuing one more unit of debt equals the marginal cost of debt (in the form of increased cost of distress and bankruptcy). In the pecking-order theory, firms raise external funds by choosing the instrument that is the most advantageous given the information asymmetry the firm faces.
More recently, this demand-centric approach to understand capital structure has been called into question. Baker and Wurgler (2002) argue that capital structure is the cumulative outcome of a series of financing decisions in which managers take advantage of temporary market misevaluations, while Welch (2004) argues that managers fail to counteract the mechanistic effects of stock returns on their capital structure and therefore capital structure is almost entirely determined by lagged stock returns. These contributions only focus on the equity/debt choice, implicitly assuming a perfect substitutability between different sources of debt.
However, in cases in which different sources of debt are not perfect substitutes, any variation in credit supply conditions affecting one of them (e.g., the public bond market) will affect the overall leverage. One source of such variation in credit supply conditions is the investor's credit supply uncertainty. For example, suppose that firm A issues a bond and that this is held by more "stable" investors - i.e., investors who are more likely to stay invested in the market for the long-run. In this case, when firm A's debt matures and the firm needs to refinance it, current owners of the maturing debt will be likely to be able to roll over the existing debt.
Now, suppose that firm B is identical to firm A in all demand-side characteristics but that its bond is held by less stable investors - i.e., investors who are less likely to be in the market for the long run. In this case, there is a higher probability that the current investors' supply of credit deviates from the amount that firm B needs to refinance its debt when the existing debt matures. That is, there may be supply-induced reasons that generate an imbalance in the credit supply.
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Determinants of Mutual Fund Performance Persistence: A Cross-Sector Analysis
