Leverage Choice and Credit Spreads when Managers Risk Shift

We model the debt and asset risk choice of a manager with performance-insensitive pay (cash) and performance-sensitive pay (stock) to theoretically link compensation structure, leverage, and credit spreads. The model predicts that optimal leverage trades off the tax benefit of debt against the utility cost of ex-post asset substitution and that credit spreads are increasing in the ratio of cash-to-stock. Using a large cross section of U.S.-based corporate credit default swaps (CDS) covering 2001 to 2006, we find a positive association between cash-to-stock and CDS rates, and between cash to-stock and leverage ratios. CEO compensation typically includes both performance-sensitive and performance-insensitive components. This pay structure can be readily ratio nalized in a contracting setting (e.g., Holmstrom (1982)). Performance-sensitive payments link a manager's value-enhancing actions to his wealth, thereby aligning his incentives with those of the firm. These payments are risky, how ever, and in contracts with a risk-averse manager risk-sharing motives give rise to a role for the performance-insensitive component. Because compensa tion structure has a direct impact on manager objectives, it is natural to expect * Murray Carlson is from the Sauder School of Business at the University of British Columbia; Ali Lazrak is from the Sauder School of Business at the University of British Columbia and HEC Paris. We thank seminar participants at Carnegie Mellon University, Connor, Clark, and Lunn In vestment Management Ltd., HEC Lausanne, HEC Paris, Northwestern University, the Stockholm School of Economies, the University of British Columbia, the University of Calgary, the University of Colorado at Boulder, the University of Illinois at Urbana Champaign, the 2005 Northern Fi nance Association Meetings, the 2006 Society for Economic Dynamics, the 2007 American Finance Association Meetings, the 2008 French Finance Association Meetings, the 2009 European Finan cial Association Meetings, as well as two anonymous referees, the Associate Editor, Ulf Axelson, Haijoat Bhamra, Ivar Ekeland, Adlai Fisher, Thierry Foucault, Lorenzo Garlappi, Ron Gi ammarino, Robert Goldstein, Rick Green, Cam Harvey (the Editor), Ulrich Hege, Rob Heinkel, Tim Johnson, Marcin Kacperczyk, Erwan Morellec, Hernan Ortiz-Molina, Michael Roberts, Jean Charles Rochet, Dion Roseman, Neal Stoughton, Ilya Strebulaev (AFA discussant), Per Stromberg, Suresh Sundaresan, Michael Troege (FFA discussant), Fernando Zapatero, Josef Zechner (EFA discussant), Jaime Zender, and Song Zhongzhi for helpful comments. We are grateful to Markit Group Limited for providing us with credit default swap rate data and to Maryam Rastegar and Sandy Tanaka for their administrative help in acquiring these data. Financial support from the Social Sciences and Humanities Research Council of Canada (grant #410-2006-1345) is gratefully acknowledged. An Internet Appendix for this article is available online in the Sup plements and Datasets section, containing supplementary results and supporting material, at http ://www. afajof. org/supplements. asp.

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