Credit Quality Firms Research Articles

How does credit risk affect cost management strategies? Evidence on the initiation of credit default swap and sticky cost behavior

In this paper, we examine the effect of credit defaults swaps (CDS) initiation on reference firms' cost management strategies. CDS contracts provide insurance protection for creditors, inducing a shift in bargaining power from borrowers to creditors and an excessive incidence of bankruptcy. Anticipating more intransigent creditors in debt renegotiations and higher bankruptcy risk, CDS firms are incentivized to mitigate risk through decreasing cost stickiness after CDS initiation, as cost stickiness lowers liquidity and triggers early covenant violations. We find that, on average, CDS initiation is associated with a decline in reference firms' cost stickiness. This association is more pronounced for less liquid, financially distressed, and lower credit quality firms. We also find that CDS firms with a reduction in cost stickiness will exhibit lower future bankruptcy risk than CDS firms without such as reduction in stickiness. Collectively, our findings suggest that the CDS-induced “empty creditor problem” causes reference firms to undertake more conservative cost management practices to alleviate downside risk.

CREDIT QUALITY AND SUBSTITUTION IN SME FINANCE

We investigate whether and how SMEs’ credit quality influences their substitution of bank credit for trade credit. Using data from the five largest European countries, we find that substitution of bank credit for trade credit decreases during the financial crisis, but it decreases significantly less for ex ante low credit quality firms. We control for pre-crisis or lagged firm characteristics including size and external finance dependence, industry effects, sample selection effects and cross-country heterogeneity. We also find that low credit quality firms increase their absolute and relative trade credit usage significantly more than high credit quality firms during the financial crisis. The effects are consistent across countries and stronger for net trade credit borrowers and financially constrained firms. The evidence highlights how credit quality influences demand-side driven substitution in SME finance.

Credit Lines and the Liquidity Insurance Channel

AbstractWe suggest a new mechanism—the liquidity insurance channel—based on the widespread reliance of high credit quality firms on bank credit lines for liquidity management. Our model matches the patterns of usage of loans and credit lines in the cross‐section of firms and defines the conditions under which shocks to bank health affect primarily low or high credit quality firms. Our framework can explain why credit line origination is more cyclical than loan origination. Overall, we uncover a novel interaction between bank health and economic activity through the provision of bank credit lines to high credit quality firms.

Liquidity risk and maturity management over the credit cycle

We show that firm demand-side factors are strong drivers of procyclical refinancing behavior over the credit cycle using novel data from the Shared National Credit program. Firms are more likely to refinance early when credit conditions are good to keep the effective maturity of their loans long and hedge against having to refinance in tight credit conditions. High credit quality firms are better able to hedge, making their refinancing propensity more sensitive to credit cycles than less creditworthy firms. There is a strong relationship between refinancing a loan, and subsequent growth in capital expenditure, especially when a loan is refinanced early.

Credit Lines and the Liquidity Insurance Channel

We provide a new perspective on bank-dependency - the (bank) "liquidity insurance channel" - based on the predominance of large, high credit quality firms among credit line users. Our model can match the pattern of bank dependency in the cross-section of firms, and predicts when shocks to bank health will affect primarily low or high credit quality firms. Our framework can also explain why credit line origination is more cyclical than loan origination. Overall, we uncover an important link between bank health and economic activity through the provision and effectiveness of bank credit lines to large, high credit quality firms.

Multi-Market Trading and Cross-Asset Integration

We study how trading in multiple markets affects the integration of a firm’s capital structure. Using daily data on cross-listed securities and credit default swaps (CDS) traded around the world, we find that foreign listing improves the synchronicity between firm stock and CDS returns. This effect is robust to the inclusion of market and firm-level controls, and it manifests itself most profoundly among larger, more liquid, better credit quality firms, as well as among firms with higher analyst coverage. Integration tests reveal that, after foreign listing, firm-specific credit risk becomes more exposed to both world and local equity market risks, with a larger change in the world market beta. Our results suggest that cross-listings have an important impact on debt and equity market integration, and that this integration is more easily attained for securities of more visible firms.

Analysts' Forecast Bias and the Mispricing of High Credit Risk Stocks

This paper investigates whether financial analysts' power to move prices arises from investors' tendency to blindly follow analyst earnings forecasts. We find that the degree of optimism or pessimism in these forecasts is predictable and leads to temporary distortions in the stock prices of firms with difficult-to-forecast earnings. For example, among stocks with poor credit quality, the quintile predicted to have the most conservative forecasts outperforms the quintile with the most optimistic forecasts by a risk-adjusted 13.2% per year. For better credit quality firms, analyst bias is unrelated to subsequent stock returns. Firms susceptible to imprecision in earnings forecasts, like those with to poor credit quality, large idiosyncratic volatility, or high forecast dispersion, are much more likely to have highly optimistic forecasts. The greater analyst optimism for these types of stocks explains their lower returns and negative alphas, and offers a behavioral explanation for the credit risk, idiosyncratic volatility, and analyst dispersion anomalies.

Is Default Risk Priced in Equity Returns?

We disentangle the complexity of the distress risk premium in stock returns using the risk-neutral measure of credit risk (valued by CDS spread) and investigate the relation between credit risk and the market beta, size, value, and momentum effects. Consistent with the argument of the negative distress premium, firms with higher credit risk have lower stock returns, and a positive value effect is concentrated in high credit quality firms. However, credit risk is positively priced in returns on stocks that won most in the past year and that, during the crisis, comove most with the market. A positive momentum effect is concentrated in high credit risk firms. Furthermore, the size effect, but not the value effect, could be attributed to a positive credit risk effect.

Time to change. Rating changes and policy implications

The recent financial crisis manifested the criticism to rating agencies of being slow in adjusting their rating to current conditions. This paper examines the timeliness of rating changes and identifies factors which result in ‘stickiness’ of rating actions. Knowledge of the stickiness of rating agencies is a first step in designing a more appropriate rating system. Stickiness is characterized by not adjusting the rating even when a market-based estimate of default probability changes. Extending an econometric model of friction the migration policy is modelled in terms of thresholds which have to be crossed by default probability estimates before an up- or downgrade occurs. Default probability estimates have to change by two notches before the rating agency reacts. The timeliness differs across the rating spectrum and over the years. During periods with high defaults and for low credit quality firms agencies tend to rate more timely.

Financial Distress and the Cross‐section of Equity Returns

ABSTRACTWe explicitly consider financial leverage in a simple equity valuation model and study the cross‐sectional implications of potential shareholder recovery upon resolution of financial distress. Our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book‐to‐market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump‐shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.

The Financial Sector and the Real Economy During the Financial Crisis: Evidence from the Commercial Paper Market

Shocks to the financial sector led credit spreads to widen to unprecedented levels in many markets during the 2007-2008 financial crisis. The rise in spreads attracted attention because it could signal a disruption in financial markets, which has been widely linked to an increased burden on non-financial firms. This paper disentangles the relative contributions of credit and liquidity risk in explaining the widening of commercial paper spreads. In doing so, we find that liquidity risk was isolated to the financial sector throughout the first two major shocks to the system (August 2007 and March 2008). Indeed, controlling for credit risk, non-financial corporations saw little or no change in the cost of funding during this time period. After the bankruptcy of Lehman Brothers, for the first time, liquidity problems in the commercial paper market spilled out of the financial sector into the spreads of low credit quality non-financial firms. This effect had a disproportionately larger impact on those low credit-quality non-financial firms that placed paper exclusively through financial sector dealers. High credit quality firms remained unaffected throughout. Our interpretation of the results is that markets were able to differentiate not only between safe and imperiled firms in the midst of the crisis, but also to isolate where liquidity effects were most likely to be salient.

Do hedge funds trade on private information? Evidence from syndicated lending and short-selling

This paper investigates an important contemporary issue relating to the involvement of hedge funds in the syndicated loan market. In particular, we investigate the potential conflicts of interest that arise when hedge funds make syndicated loans and take short positions in the equity of borrowing firms. We find evidence consistent with the short-selling of the equity of the hedge fund borrowers prior to public announcements of both loan originations and loan amendments. We also find that hedge funds are more likely to lend to highly leveraged, lower credit quality firms, where access to private information is potentially the most valuable and where trading on such information could lead to enhanced profits. Overall, our results have important implications for the current debate regarding regulating the hedge fund industry.

Bond Market Access, Credit Quality, and Capital Structure: Canadian Evidence

We examine the impact of bond market access (measured by having a credit rating) on leverage for Canadian high credit quality (HQ) and low credit quality (LQ) firms, and find that the leverage impact is more pronounced for LQ firms. The results are similar for U.S. firms. Our results are confirmed when we control for the firm's credit quality, examine the change in leverage around rating initiation, and account for the issue size effect. A similar leverage impact for Canadian and U.S. LQ firms suggests that the Canada-U.S. bond market integration has mitigated the financial constraints for Canadian LQ firms.

The corporate choice between public debt, bank loans, traditional private debt placements, and 144A debt issues

The main purpose of this study is to examine the determinants of the corporate choice between different forms of debt financing. By analyzing the most comprehensive sample of US corporate debt issues to date, I find that firms that issue 144A debt have significantly lower credit quality and higher information asymmetry than firms that issue traditional non-bank private debt. Further, the study shows that traditional private placements, rather than bank loans, are the favorite private debt source for firms with good credit quality. I also show that the firm characteristics of traditional private debt issuers have significantly changed after 1990 through to 2003. My results suggest the following pecking order of debt choices which is conditional on credit quality. In other words, high credit quality firms prefer public bond offerings and small firms, with good credit quality, are more likely to issue traditional private debt. A large group of firms characterized by moderate credit quality make extensive use of bank loans and poor credit quality firms preferentially issue 144A debt.

Distance Still Matters: The Information Revolution in Small Business Lending and the Persistent Role of Location, 1993-2003

In a seminal article on small business lending, Petersen & Rajan (2002) argue that technological changes have revolutionized small business lending markets, weakening the reliance of small businesses on local lenders and increasing geographic distances between firms and their credit suppliers. While their data only cover through 1993, they conjecture that the pace of change accelerated after 1993. Using the 1993, 1998, and 2003 Surveys of Small Business Finances (SSBFs), we test whether the distance changes identified by Petersen and Rajan continued or accelerated during the following decade. Using a novel application of Oaxaca-Blinder decomposition, we identify the extent to which specific observable characteristics are associated with distance changes and draw three conclusions. First, while distances increased between 1993 and 1998 at a faster rate than found by Petersen & Rajan, distance increases appear to have halted or possibly reversed between 1998 and 2003. Second, rather than increasing proportionally for all small firms, distance increases were uneven across firms over the decade, with higher credit quality firms and firms with more experienced ownership realizing greater gains in distance than other firms. Finally, distances increased faster at older firms and, regardless of firm age, increases in distance have only affected some product types, primarily those involving asset-back loans (including mortgages). For relationships that involved the provision of either lines of credit or multiple types of credit, distances increased very little or not at all during the decade. This analysis provides a detailed and nuanced view of how the market for small business credit has evolved during a period of rapid technological change.

Capital Structure and Debt Structure

Using a novel data set that records individual debt issues on the balance sheets of public firms, we demonstrate that traditional capital structure studies that ignore debt heterogeneity miss substantial capital structure variation. Relative to high credit quality firms, low credit quality firms are more likely to have a multi-tiered capital structure consisting of both secured bank debt with tight covenants and subordinated non-bank debt with loose covenants. We discuss the extent to which these findings are consistent with existing theoretical models of debt structure in which firms simultaneously use multiple debt types to reduce incentive conflicts.

Distance Still Matters: The Information Revolution in Small Business Lending and the Persistent Role of Location, 1993-2003

In a seminal article on small business lending, Petersen & Rajan (2002) argue that technological changes have revolutionized small business lending markets, weakening the reliance of small businesses on local lenders and increasing geographic distances between firms and their credit suppliers. While their data only cover through 1993, they conjecture that the pace of change accelerated after 1993. Using the 1993, 1998, and 2003 Surveys of Small Business Finances (SSBFs), we test whether the distance changes identified by Petersen and Rajan continued or accelerated during the following decade. Using a novel application of Oaxaca-Blinder decomposition, we identify the extent to which specific observable characteristics are associated with distance changes and draw three conclusions. First, while distances increased between 1993 and 1998 at a faster rate than found by Petersen & Rajan, distance increases appear to have halted or possibly reversed between 1998 and 2003. Second, rather than increasing proportionally for all small firms, distance increases were uneven across firms over the decade, with higher credit quality firms and firms with more experienced ownership realizing greater gains in distance than other firms. Finally, distances increased faster at older firms and, regardless of firm age, increases in distance have only affected some product types, primarily those involving asset-back loans (including mortgages). For relationships that involved the provision of either lines of credit or multiple types of credit, distances increased very little or not at all during the decade. This analysis provides a detailed and nuanced view of how the market for small business credit has evolved during a period of rapid technological change.

Distance Still Matters: The Information Revolution in Small Business Lending and the Persistent Role of Location, 1993-2003

In a seminal article on small business lending, Petersen & Rajan (2002) argue that technological changes have revolutionized small business lending markets, weakening the reliance of small businesses on local lenders and increasing geographic distances between firms and their credit suppliers. While their data only cover through 1993, they conjecture that the pace of change accelerated after 1993. Using the 1993, 1998, and 2003 Surveys of Small Business Finances (SSBFs), we test whether the distance changes identified by Petersen and Rajan continued or accelerated during the following decade. Using a novel application of Oaxaca-Blinder decomposition, we identify the extent to which specific observable characteristics are associated with distance changes and draw three conclusions. First, while distances increased between 1993 and 1998 at a faster rate than found by Petersen & Rajan, distance increases appear to have halted or possibly reversed between 1998 and 2003. Second, rather than increasing proportionally for all small firms, distance increases were uneven across firms over the decade, with higher credit quality firms and firms with more experienced ownership realizing greater gains in distance than other firms. Finally, distances increased faster at older firms and, regardless of firm age, increases in distance have only affected some product types, primarily those involving asset-back loans (including mortgages). For relationships that involved the provision of either lines of credit or multiple types of credit, distances increased very little or not at all during the decade. This analysis provides a detailed and nuanced view of how the market for small business credit has evolved during a period of rapid technological change.

Financial Distress and the Cross Section of Equity Returns

We explicitly consider financial leverage in a simple equity valuation model and study the cross-sectional implications of potential shareholder recovery upon resolution of financial distress. We show that our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book-to-market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump-shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.

Agency Costs, Bank Specialness and Renegotiation

This paper proposes the yield spread between public bonds and bank loans of the same firm (the Bond-Bank spread) as a measure of compensation for agency costs that cannot be mitigated by bondholders but can be mitigated by banks due to their ability to monitor the firm and renegotiate the loan. In a model of debt pricing and choice, the tradeoff between firm moral hazard and bank opportunism, leads to co existence of relationship debt (bank loans) and uninformed debt (bonds) in its capital structure. Contrary to common concerns, bank oversight actually increases in the presence of bonds. Using a large and unique data set of bond and bank yields, for the same firm at the same point in time, matched by Credit Rating, Seniority, Maturity and adjusted for collateral differences, it is shown that the Bond - Bank Spread is negative for high credit quality firms and positive for low credit quality firms, consistent with the theoretical model. Applying a new econometric methodology on matching developed by Heckman et al(1998), the results of the sample are confirmed. The Bond - Bank Spread is about -76 basis points for A borrowers, 75 and 53 basis points for BBB and BB borrowers, increasing to 173 and 335 basis points for the B and CCC rated borrowers respectively. Thus agency costs or the specialness of banks seem to be important for BBB and below investment grade firms across the credit spectrum.