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Public Debt as a Punching Bag: An Agency Model of the Mix of Public and Private Debt

Firms with publicly-issued debt typically obtain a large fraction of their debt finance from private lenders. We show that public debt can complement private lender monitoring, in effect making private debt contracts more complete. Public debt carries few control rights, leaving bondholders vulnerable to exploitation in renegotiations between the firm and private lenders. The firm is motivated to make more efficient investment choices in order to preserve options to undertake such exploitations. Our model differs from previous literature by assuming there is no private information. Thus, the model is most relevant to the debt structure of large firms, those most likely to have a mix of public and private debt.