Capital Structure and the Yield Curve

We develop a dynamic capital structure model where interest rates are stochastic and driven by three state variables: level, slope, and curvature of the yield curve in an arbitrage-free Nelson-Siegel model. Our analysis suggests that the yield-curve factors are critical determinants of the capital structure of firms and that an increase in any of the three factors are followed by an increase of the firm's debt and a shortening of its debt maturity. Using data on US firms from 1985 to 2020, we perform two-stage least squares system of equations that account for the joint determination of leverage and debt maturity and confirm our model's predictions