Callable Bonds: A Risk‐Reducing Signalling Mechanism

Abstract

ABSTRACT The theory of financial economics has failed to distinguish advantages of callable bonds from those of short‐term debt. This paper shows that either type of borrowing can signal a firm's better prospects but that short‐term debt does so at the cost of weakened risk‐sharing with capital markets. By issuing either equity or long‐term, non‐callable debt, a firm with poor investment opportunities will not pool its prospects with those of a better firm. But equity produces superior risk‐sharing. Perhaps this explains the almost complete absence of long‐term, non‐callable bonds from observed corporate capital structures.