RISK SHIFTING AND BONDHOLDERS - It is often argued that bondholders who plan to hold their...

RISK SHIFTING AND BONDHOLDERS - It is often argued that bondholders who plan to hold their bonds until maturity and collect the coupons and the face value are not affected by risk shifting that occurs after they buy the bonds, because the effect is only on market value. Do you agree? Explain.

Expert Solution

Risk shifting is defined as the tendency shown by the stockholders of a firm to take on more risky projects than bondholders expect them to take. This is also known as asset substitution. ‘The Theory of the Firm’ given by Jensen and Meckling (1976) states that when the company engages in risky projects, there is a transfer of wealth from bondholders to shareholders. The idea here is that by investing in risky projects the firm will have higher firm risk. This will increase the risk of the equity and the probability of bankruptcy will also increase. In such a situation, the bondholders will prefer to sell the bond of the company and not hold it till maturity. Therefore, I do not agree that bondholders who plan to hold their bonds until maturity and collect the coupons and the face value are not affected by risk shifting that occurs after they buy the bonds. The main reason for not agreeing to the statement is that there will hardly be any such bondholder who will hold the bond till maturity in the risk shifting scenario.

Reference:

Jensen, M.C., Meckling, W.H., 1976. Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3, 305–360.

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