The phrase ''corporate debt'' usually conjures up the picture of a security that promises periodic fixed-coupon payments and a larger face value payment at maturity. Potentially, however, the stream of periodic payments over the life of a debt security can be structured several ways. For example, in addition to fixed periodic coupon payments as with standard fixed-coupon bonds, periodic payments can be made contingent on the accounting earnings of the issuing corporation in each period as with income bonds, or there can be only one payment at maturity as with zero-coupon bonds. Debt securities with all of the above three payment structures have been issued; however, in practice, most corporate debt carries a fixed coupon. Corporate reluctance to issue the other two types of debt securities, income bonds and zero-coupon bonds, has long puzzled academic researchers as well as practitioners. Adding to the puzzle is the fact that both income bonds and zero-coupon bonds possess some distinct advantages over the fixed-coupon bond. Coupons on income bonds are payable only if earnings are sufficiently high and failure to pay a coupon does not entail a risk of bankruptcy. Additionally, despite their income-contingent nature. paid coupons on income bonds are deductible from income for tax purposes. Despite these advantages, income bonds have rarely been issued in recent years. Similarly, zero-coupon bonds, in addition to substantially decreasing the possibility of bankruptcy during the period to maturity, also appear to have a significant investor demand. This demand has been fulfilled not by nonfinancial corporations issuing these bonds but by financial intermediaries who have created zero-coupon debt instruments from existing coupon-bearing debt (mostly issued by the government). This paper provides a possible economic explanation for corporate reluctance to issue debt securities such as income and zero-coupon bonds. We show that, if the insiders of an issuing corporation have private information about the future cash flows of the corporation, debt contracts that do not provide for fixed and obligatory periodic payments appear to cause more mispricing than debt contracts that do carry such provisions. This mispricing represents the subsidy that a corporation with an ''inferior'' distribution of future cash flows receives at the expense of one with a ''superior'' cash flow distribution. As a result, a debt contract that incorporates a contingent payment feature (such as an income bond) or one that does not promise an intermediate periodic payment (such as a zero-coupon bond) is perceived by the uninformed rational market participants as an unfavorable signal about the future prospects of the issuing corporation. This explanation, in particular for the near nonexistence of income bonds, is consistent with the popular notion that income bonds have a stigma, an ''odor of death,'' attached to them. The main results outlined above are obtained in a framework in which the costs associated with financial distress are insignificant. When financial distress costs are included in the framework, the results are as follows: (i) if the cost is sufficiently low, the results are unchanged, that is, firms will issue only fixed-coupon bearing debt, (ii) if distress costs are a little more than in (i) but not high, the higher-quality firm will issue fixed-coupon debt and the lower-quality firm will be indifferent between fixed-coupon and contingent-coupon debt; (iii) in the next higher range of distress costs, the better firm will choose to issue fixed-coupon debt and the lower-quality firm will choose contingent-coupon debt; and (iv) if distress costs are sufficiently high, firms will issue only contingent-coupon debt. There are several issues in the design and packaging of securities that are not addressed in this paper. Based on our results, however, it appears that when there is asymmetric information, many types of contingencies may be problematic because lower-quality firms will benefit more from them than the higher-quality ones. Thus, the choice of contingency and its effects on investor beliefs is likely to be an important factor in security design.
