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Institutional Investment - May 30, 2011

Optimal Design of Corporate Market Debt Programmes in the Presence of Interest-Rate and Inflation Risks

In a climate of increasing inflation uncertainty, EDHEC-Risk Institute has released a new study analysing optimal corporate debt management policies. The study, produced as part of the research chair on “The Case for Inflation-Linked Corporate Bonds: Issuers’ and Investors’ Perspectives,” in partnership with Rothschild & Cie, entitled “Optimal Design of Corporate Market Debt Programmes in the Presence of Interest-Rate and Inflation Risks,” examines the optimal liability structure when the issuer faces such instruments as fixed-rate debt, floating-rate debt, and inflation-linked debt.

The authors of the study, Lionel Martellini, Scientific Director, and Vincent Milhau, Senior Research Engineer, EDHEC-Risk Institute, introduce a general framework with which a corporation subject to default risk may make optimal debt-management decisions.

The main findings of the study are the following:

  • Debt management has an impact on capital structure. A primary contribution of the paper is to provide a joint quantitative analysis of capital-structure decisions and debt-structure decisions within a standard continuous-time model in the presence of interest-rate and inflation risks.

  • An optimal debt structure can facilitate substantial increases in firm value. Issuing floating-rate bonds or inflation-linked bonds may increase risk from the perspective of pure debt management, but it may decrease risk from the perspective of integrated asset/liability management. From this trade-off emerges an optimal debt structure, and one can show that under mild simplifying assumptions, minimising the volatility of assets nets of liabilities is equivalent to minimising the risk-adjusted probability of default, which is in turn equivalent to maximising firm value.

  • A number of corporations would benefit from issuing inflation-linked bonds, bonds usually associated with sovereign states. If a firm’s revenues grow with inflation, issuing some inflation-linked debt can be a natural hedge.

This study was produced as part of the research chair on “The Case for Inflation-Linked Corporate Bonds: Issuers’ and Investors’ Perspectives” in partnership with Rothschild & Cie.