Alternative Tests of Agency Theories of Callable Corporate Bonds

According to agency theories, the prevalence of callable bonds arises from asymmetric information, a risk incentive or asset substitution problem, or an under investment problem. These theories are difficult to distinguish empirically because there are no direct measures of agency costs. Previous studies have found support for agency theories as a group, focusing on whether a bond has a call provision. We examine several areas in which the various theories are distinguishable: the subsequent rating changes of the bonds, the distribution of first call dates, the investment activity of bond issuers, and the value of the call options. We also examine trends in the use of call options over time. Based on a sample of industrial bonds issued between 1987 and 1991, our alternative tests provide evidence against the three agency theories. We conclude that agency theory, while potentially important for some firms, is unlikely to be the most important explanation of callable corporate bonds.