Debt Complexity and Equity Behavior

Abstract

I examine how the complexity of firm debt affects the incorporation of news into equity prices. As residual claimants to firm cash flows, equity investors must be able to value all outstanding debt contracts, suggesting that complex debt can interfere with their ability to process news effectively. Using a model in which debt complexity causes a subset of investors to initially underweight news precision, I derive three predictions for the equity behavior of debt-complex firms around news events: (1) they exhibit greater post-announcement drift, (2) they show elevated trading volume both on announcement day and in the post-announcement period, and (3) their return volatility decreases on announcement day but increases during the post-announcement period. These predictions are supported by empirical evidence in the context of earnings announcements, suggesting that debt complexity introduces meaningful frictions in how news is incorporated into equity markets.