Leverage and Interest Rates

We study the sensitivity of optimal leverage to the level of the risk-free interest rate. Our trade-off model implies a heterogeneous response depending on the presence of a sponsor backing company debt. A highly-leveraged, backed company optimally increases debt when interest rates fall, while a company without a sponsor reduces it despite having lower initial leverage. This heterogeneity implies divergent bankruptcy probability and recovery-upondefault, in the same interest rate scenarios, for the two company types. We also show that a lower risk-free rate reduces the sponsor’s incentive to issue debt. JEL Classification: G32, H32, L32