Junk Bonds, Bank Debt, and Financial Flexibility

New issues of public high yield debt, or junk bonds, reached record levels in the 1990s. This paper studies transactions where firms issue junk bonds and use the proceeds to repay their bank debt. These substitutions represent the most frequent use of junk bonds. Our analysis suggests that firms undertake these substitutions to preserve financial flexibility--a capital structure's ability to support activities at low transaction and opportunity cost. Junk bond substitutions typically occur around negative earnings surprises. Since junk bonds contain substantially fewer and less restrictive covenants than bank debt, and also mature later, these substitutions reduce the probability of default and increase the range of activities in which firms can engage. The earnings surprises are short-term, and firms eventually reborrow from banks. Junk bond issues convey negative information about sample firms' prospects and cause stock prices to fall, but the decline is less severe for firms that benefit more from the increased financial flexibility. While giving managers increased flexibility could also harm shareholders (by allowing them to take actions that reduce firm value) our evidence does not strongly support this possibility