Managerial Compensation and Corporate Bond Yield with Active Shareholders

In this paper we show how a greater pay-for-performance in managerial compensation may reduce the cost of corporate debt. The model points to the relation between the bonus and the monitoring effort by shareholders as key to reduce the cost of debt and hence increase the value of the company. Incentivizing the manager with a bonus related to the company’s performance, provided that the information is disclosed to investors, not only reduces the moral hazard between managers and shareholders, but more importantly between shareholders and bond-holders. The model predicts i) a lower corporate bond yield when there is disclosure of managerial pay-performance to financial markets, and ii) an increasing degree of managerial pay-for-performance with company’s leverage.