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We propose a novel framework for investigating learning dynamics on the debt market. Observing a firm’s survival of apparently distressed periods, the market eliminates asset value estimates that are too low to be consistent with the observed survival. Therefore, the firm’s cost of debt becomes lower for given financials. Relative to a perfect information setting, the firm strategically delays default to benefit from a subsequently lower cost of debt. Default comes as a surprise, as it reveals the currently worst possible asset value as correct. The surprise effect is mitigated for debt with higher performance sensitivity and for lower ex ante information asymmetry.

This paper was accepted by Gustavo Manso, finance.

Funding: This work was supported by Danmarks Frie Forskningsfond [Grant 0133-00087B], Australian Research Council [Grant DP160104737], the Deutsche Forschungsgemeinschaft [Grant 282079427], Fundamental Research Funds for the Central Universities of China [Grant 18wkpy36], and the Danish Finance Institute (DFI).

Supplemental Material: The data files and online appendices are available at

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