DEFINITION of 'Debt Signaling'

A theory that states that an announcement regarding a firm's debt can be used as a signal of the stock's future performance. A company announcement regarding the issuance of debt is said to signal positive news, while an announcement that states that debt will be taken on at a future date is said to be a negative signal about the company.

BREAKING DOWN 'Debt Signaling'

When a company agrees to take on more debt, it is making a commitment to pay interest on the debt. In doing so, it is showing that the company is in a stable financial situation. Conversely, when the amount of future debt is reduced, investors may see this as a sign that the company is unable to make its interest payments and is in a weak financial situation.

Studies regarding debt announcements and the signals they provide have shown statistically significant results that this theory does actually occur in real life. Subsequently, the theory has been used by proponents of the inefficient market hypothesis.

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