Abstract

We examine liquidity of corporate debt and capital structure of the firm run by inefficient management in the presence of a distressed investor in the secondary debt market. In addition to having superior information about the firm’s future cash flows, the distressed investor can install a more efficient management and restructure the firm in bankruptcy. An unexpected arrival of the investor negatively impacts liquidity of existing debt claims. However, liquidity is more nuanced when firms choose their capital structure in expectation of the distressed investor. In particular, if value added from restructuring is sufficiently high in deep default states, liquidity of senior claims optimally issued by the firm can still be low. We derive testable implications and examine the impact of various Bankruptcy Code provisions on liquidity and capital structure of the firm.