Financially Sophisticated Firms

Abstract

Using comprehensive new data on firms, bond issuance, and portfolio holdings, we show that firms strategically choose their bond structures to simultaneously reduce their cost of capital and mitigate ”financial fragility”—their exposure to investor demand shocks. By tailoring bonds to specific investor preferences, firms shape their bondholder composition and thereby manage their exposure to demand-based risks. Firms value low exposure to demand-based risk because it enhances resilience to credit shocks and creates firm value. However, because bonds with low demand risk trade at a discount, firms face a fundamental trade-off: they must choose between minimizing their cost of capital and reducing financial fragility. Our findings bridge asset pricing and corporate finance by demonstrating how bond supply endogenously responds to investor demand patterns.