Debt Holders Research Articles

Substitute or complement? The use of trade credit as a financing source among SMEs

PurposeThis study aims to investigate trade credit as a financing source among small- and medium-sized enterprises (SMEs), particularly the influence of short-term debt, long-term debt and profitability on the use of such credit.Design/methodology/approachOrdinary least squares (OLS), fixed-effects and generalized method of moments (GMM) system models were used to analyze a large cross-sectional panel data set of 15,897 Swedish SMEs in five industry sectors for the 2009-2012 period.FindingsThe study provides empirical evidence that long-term debt and profitability each significantly and negatively influence trade credit (i.e. accounts payable) and that short-term debt positively influences trade credit. Notably, while trade credit seems to complement other short-term debt, it replaces long-term debt. Moreover, firm size in terms of sales is positively related and firm age is negatively related to accounts payable. Industry affiliation is another significant explanatory variable.Practical implicationsThe results provide debt holders, potential investors, policymakers and academic researchers with insights into the relationship between trade credit demand, on the one hand, and external financing (i.e. short- and long-term debt) and internal retained earnings (i.e. profit), on the other. From a manager’s perspective, the findings may be important for decision-making regarding trade credit use.Originality/valueWhen investigating trade credit determinants, the literature has seldom distinguished between short- and long-term debt and considered that they may influence the use of trade credit in different ways. The present study adds to the literature by using OLS, fixed-effects and GMM system models to analyze a large cross-sectoral sample in a high-tax country where both bank loans and trade credit are considered important financing instruments.

Beyond Home Bias: Portfolio Holdings and Information Heterogeneity

We show that international portfolios reflect the underlying heterogeneity in investors' beliefs. Using data on foreign sovereign debt holdings of European banks matched with their forecasts on future bond yields, we find that expecting higher returns and having more accurate forecasts are associated with larger bond holdings. Crucially, the elasticity of portfolio holdings to expected returns is increasing in the precision of the forecast, implying that investors optimally exploit comparative advantages in information production. We rationalize the results in a model where partial information specialization arises endogenously by introducing some degree of unlearnable uncertainty about asset payoffs.

Beyond Home Bias: Portfolio Holdings and Information Heterogeneity

We provide new evidence that international portfolios reflect the underlying heterogeneity in investors' beliefs. Using data on foreign sovereign debt holdings of European banks matched with their forecasts on future bond yields, we find that expecting higher returns and having more accurate forecasts are associated with larger bond holdings. Crucially, the elasticity of portfolio holdings to expected returns is increasing in the precision of the forecast, implying that investors optimally exploit comparative advantages in information production. We rationalize the results in a model where partial information specialization arises endogenously, which leads to further testable implications that we confirm in the data.

Hazardous Tango: Sovereign-Bank Interdependencies Across Countries and Time

Sovereign-bank feedback loops have been at the heart of the euro area crisis and many previous debt crises. We regress a market measure of interdependency – the correlation between sovereign and bank credit default swaps (CDS) – against various fundamental indicators of interlinkages and risk for 65 banks from 23 countries from Q1 2006 to Q4 2015. We find evidence that direct sovereign debt holdings of banks, implicit contingent liabilities of the government to banks and market volatility are significantly linked to higher correlations. While such CDS correlations are generally higher for banks in countries bank-based financial systems, we do not find these channels to be stronger in these countries than market-based systems. Finally, we find that bank CDS levels perform better in explaining sovereign CDS levels in periods of high volatility. Overall, these results support the notion of non-linear effects and spillovers in CDS markets.

Volatility and the Priority Structure of Corporate Debt

This paper examines how exogenous shocks to volatility affect the priority structure of corporate debt. We argue that increases in volatility reduce corporate debt capacity and increase the potential for dilution of existing debt holders. We hypothesize that as the potential for dilution increases, debt holders will attempt to mitigate dilution by establishing priority through collateral grants rather than through negative pledge covenants. More important, we hypothesize that increases in volatility increase the cost of senior debt relative to secured and subordinated debt which results in priority spreading; with firms increasing their reliance on both secured and subordinated debt and reducing their reliance on senior unsecured claims. We use industry level changes in tariffs and exchange rates to instrument for exogenous changes in volatility. Overall, we find that increases in volatility are associated with reductions in the use of debt, and a shift in debt structure towards secured bank debt, subordinated and convertible debt, and away from reliance on senior unsecured debt. Consistent with an increase in creditor control rights we find that increases in volatility are associated with an increase in covenant intensity of new debt issues.

Option incentives, leverage, and risk-taking

While there is extensive research on how option incentives in executive compensation relate to risk-taking by managers, the impact of capital structure on this relationship has received little empirical attention. Extant work suggests that heightened managerial career concerns arising from financial risk and monitoring by debt holders will result in leverage dampening the relationship between managerial risk-taking and equity-linked incentives. We empirically evaluate this contention and find that firm leverage is associated with a significant weakening of the positive relationship between option incentives in flow compensation and managerial risk-taking. This result holds after accounting for the endogeneity of the firm leverage and incentive compensation decisions, and is robust across alternative measures of managerial risk-taking and to using the firm's credit ratings instead of leverage. The attenuating effect of firm leverage arises from both the long-term and short-term components of debt and is significantly stronger during the financial crisis of 2007–2009. Overall, the evidence highlights the influence of capital structure on the relationship between option incentives and managerial risk-taking.

Independent celebrity directors in closely held financial institutions

Abstract This paper addresses corporate governance issues around the use of celebrity independent directors in closely held financial institutions. In doing so we illustrate how the power of the celebrity nature of the directors encouraged deposits from members of the public who would not have normally utilised a finance company. The authors employ the failure of Lombard Finance, a closely held New Zealand finance company, to illustrate the agency conflict between directors, who were nominally independent, and outside debt holders. This approach is taken as New Zealand finance companies are unique in that they are predominantly closely held bank-like firms who sourced the bulk of their funds from retail fixed term deposits. The research highlights the conflict inherent when utilising independent celebrity directors as spokespeople for closely held finance companies in a small, loosely regulated market. As a result of the failure of companies such as Lombard, the government changed the law to prevent the use of celebrity spokespeople promoting finance companies. This research contributes to the academic discussion surrounding independent celebrity directors and their influence in the collapse of closely held finance companies at a particular time in recent history and the practical steps taken to ensure that such episodes are lessened in the future.

Sovereign risk and deposit dynamics: evidence from Europe

ABSTRACTThe unprecedented expansion of sovereign balance sheets since the beginning of the global crisis has given a new meaning to the term sovereign risk. Developments in Europe since early 2010 revealed new challenges for the functioning of private banks in an environment of heightened sovereign risk and may have contributed to deleveraging. The article uses an innovative way of measuring the perception of sovereign risk and its impact. Using an extension of a common market discipline framework, it shows that exposure to sovereign risk may have limited the ability of banks in Europe to collect deposits. Potential identification issues between deposits and bank efficiency are controlled by using data envelopment analysis (DEA). The results are robust to inclusion of conventional measures of bank performance and the sector-wide holdings of foreign sovereign debt.

Greek Debt Restructuring and Investment Treaty Arbitration: Jurisdictional Stumbling Blocks for Bondholders

The recent award of an International Center for the Settlement of Investment Disputes (ICSID) tribunal in Poštová banka a.s. and ISTROKAPITAL SE v. Hellenic Republic came as an unpleasant surprise for holders of Greek sovereign debt, who suffered losses because of the sovereign debt restructuring (SDR) that took place in February 2012, since it seems to be at odds with past case law on the matter. The tribunal found that it did not have jurisdiction to hear the dispute, inter alia, because the acquisition of Greek sovereign bonds by Poštová banka did not constitute an ‘investment’ under Article 1(1) of the Greece-Slovakia Bilateral Investment Treaty (BIT). At any rate, according to the tribunal, transactions over sovereign bonds on the secondary markets do not fall within the definition of ‘investment’ under Article 25 of the ICSID Convention. In this article, the author questions the narrow interpretation of the definition of ‘investment’, as set forth in Article 1(1) of the Greece-Slovakia BIT, adopted by the tribunal. In declining jurisdiction, the tribunal looked through the provisions of Greek law so as to ascertain whether the claimants had rights protected under the BIT. The author advocates a different interpretation of the relevant provisions of Greek law in accordance with legal doctrine in Greece concerning the rights of investors over dematerialized government debt. The author also supports a wide meaning of the term ‘investment’ under Article 25 of the ICSID Convention, so that sovereign bonds are included in the definition.

THE MYSTERY OF THE PRINTING PRESS: MONETARY POLICY AND SELF-FULFILLING DEBT CRISES

We study the mechanism by which unconventional (balance-sheet) monetary policy can rule out self-fulfilling sovereign default in a model with optimizing but discretionary fiscal and monetary policymakers. By purchasing sovereign debt, the central bank e§ectively swaps risky government paper for monetary liabilities only exposed to inflation risk, thus yielding a lower interest rate. We characterize a critical threshold for central bank purchases beyond which, absent fundamental fiscal stress, the government strictly prefers primary surplus adjustment to default. Since default may still occur for fundamental reasons, however, the central bank faces the risk of losses on sovereign debt holdings, which may generate ine¢cient inflation. This risk does not undermine the credibility of a backstop, nor the ability of a central bank to pursue its inflation objectives when the latter enjoys fiscal backing or fiscal authorities are su¢ciently averse to inflation.

How Lenders Evaluate Lawsuits? Evidence from Corporate Bond Market

This paper documents how debt holders respond to possible loss of reputational capital of firms involved in corporate lawsuits revealing a significant tightening impact on issuers’ public debt properties. All else equal, investment grade bonds of litigated issuers have 4.9% higher yield spread, 11-month shorter maturity, and $14.7 million less issuance volume than propensity score matched bonds of non-litigated issuers. The effect is more pronounced in bank-loan related cases, when issuers were defendants, or lost the case. Issuers’ political connections moderate bond price sensitivity to litigations. Results suggest a causal link between litigation and cost of debt and are robust to alternative tests. Additionally, the paper reports a negative and significant abnormal bond return and excess trading volume around public announcements of lawsuits.

The literature on the interaction of fiscal risk and financial stability – A survey

This article presents a review of the literature on aspects of fiscal and financial crises. Firstly, an analysis is made on how fiscal policy may become unsustainable, whether it is due to a worsening of the fundamentals of a country, or to increasing international financial turmoil. Particular attention is paid to the literature on the role of financial institutions and their sovereign links in a crisis context. This link may mean that sovereign stress is transferred to the banks, via holdings of sovereign debt or vice versa, on account of the implicit (or explicit) guarantee that banks may have from the sovereign. Secondly, a review is made of the determining factors of the connectedness amongst financial institutions and between sovereign banks. The indicators of connectedness can help understand how systemic risk builds up. Finally, an analysis is made on how the debate on macro-prudential policy has evolved to tackle the issue of system-wide financial stress.

The Impact of the Earned Income Tax Credit on Household Finances

Expansions to the federal and state Earned Income Tax Credit (EITC) over the last two decades have made the EITC one of the largest cash transfer programs in the United States. Using a simulated instrument strategy, we analyze how policy-induced changes to the generosity of the EITC have impacted household savings and unsecured debt holdings. Using data from the Survey of Income and Program Participation (SIPP) wealth topical modules, we explore two potential mechanisms accounting for the relationship between EITC generosity and household finances: changes in the household budget set associated with expansions to the EITC and changes in labor supply due to the incentives in the benefit structure. Results suggest that a $1,000 policy-induced increase in the average household EITC leads to a 4 percentage point increase in the likelihood of holding credit card debt and a 6 percentage point increase in the likelihood of having any savings. Results are concentrated among single mothers on the phase-in portion of the EITC schedule, and are correlated with increases in labor force participation, suggesting that one of the mechanisms through which the EITC increases savings and credit card debt is through its positive impact on labor force participation and income.

The changing relevance of accounting information to debt holders over time

A number of studies have examined the change over time in the information content of accounting numbers to stockholders. However, the stockholders’ perspective is not necessarily identical to that of debt holders. The two groups face different risks and rewards, and thus their informational needs are not the same. We examine the change in the information content of accounting numbers over time from the debt holders’ perspective and hypothesize about the economic and reporting factors likely to affect this change. Using the association between accounting numbers and bond valuation and returns, we find that the information content to debt holders has increased over time. In contrast, but consistent with prior studies, we find that the information content to equity holders has declined. The results suggest that the increased information content to debt holders is related to changes in credit risk and to reporting factors such as the increase in reporting conservatism, the shift towards fair value accounting, and the increase in the frequency of losses. The findings contribute to the scant literature on the use of accounting information by debt holders and the extent to which financial reporting meets their unique needs.

The emerging regulatory landscape: a new normal

The study provides an insight on the regulatory requirements banks have been complying with since the Financial Crisis of 2009. It focuses upon the Bank Recovery and Resolution Directive’s forthcoming full implementation and its effectiveness. An empirical analysis on the European banks’ CDS market will shed light on the mechanisms driving its current and historical evolution, emphasizing the motivations for the change in the regulatory architecture. The policies will be proved to be effective in affecting investors’ risk perception that is, a shift of risk burden from senior bondholders towards subordinated debt holders, as well as a breach of the link between banks and sovereigns’ default probabilities, the so-called doom loop. Ultimately a comparative analysis on banks’ total capital, return on equity, leverage and risk weighted assets provides evidence on the impact regulations have on the European banks’ business strategies, thereby shaping the New Normal. In conclusion the paper discusses if the current regulatory regime will be enough to prevent future sources of instability.

Pari Passu at the Beginning? England, 1677

The famous Bankers Annuities granted to creditors of Charles II in 1677 contained a covenant that seems to make a clear promise of pro-rata payments to similarly-situated lenders. While the two Latin words are not actually to be found in the evidence I was able to unearth, modern-day observers of sovereign debt legalese may be able to recognize in this 17th century England covenant a pledge of inter-creditor equality similar to what these days would be known as a ratable-payments pari passu clause. Given the crucial role that these Annuities had in the pioneering development of a liquid modern government bond market in England (then as now a leading financial center), it could be asserted that a desire for strong payment equality for holders of sovereign debt would have been present at the very beginning. In that sense, this could be one of the very earliest (the earliest?) samples of such inter-creditor equality covenant pertaining to an advanced modern national debt system. Such specter of primeval ratability may be a sharp contrast to the efforts of so many relevant actors today to erase any notion of pro-rata payments from sovereign debt land.

A theory of operational cash holding, endogenous financial constraints, and credit rationing

ABSTRACTThis paper develops a theory of operational cash holding. Liquidity shocks due to delayed payments must be financed using cash or short-term debt. Debt holders provide an irrevocable credit line given a firm's expected insolvency risk, and equity holders select optimum cash holding. The model demonstrates the trade-off between cash holding and investing in fixed assets. Introducing uncertain cash flows leads to precautionary cash holding if debt holders impose financial constraints. Precautionary cash holding, in turn, reduces insolvency risk enhancing access to short-term finance. The theory shows that credit rationing can occur in the absence of market frictions. Using U.S. data from 1998 to 2012, empirical findings suggest that the decline in credit lines has contributed to the increase in cash holding in line with theoretical predictions.

Severance agreements and the cost of debt

Upon examining the language used in recent SEC filings, we find that severance agreements are often paid whether or not the CEO leaves the firm due to a change in control. We hypothesize that since severance agreements compensate CEOs in the event of termination, CEOs with these agreements will have an incentive to increase firm risk and decrease effort. Consistent with this hypothesis, we document a significant positive relation between the use of severance agreements and the cost of debt (10% higher yield spreads for firms with severance agreements). The results hold after controlling for the probability of takeover, the probability of CEO turnover, and whether the firm has investment or non-investment grade debt. These results can be explained by an increase in firm risk and a higher likelihood of CEO turnover associated with severance agreements. Overall, the evidence suggests that the effects of severance agreements extend beyond takeovers, and that these additional implications are primarily negative for the firm and for debt holders in particular.

Let Them Eat Debt But to What End? - Corporate America after the Great Recession

I study the behavior of U.S. non-financial corporates after the financial crisis. I document an increase in the real debt holdings and correspondingly the leverage for these firms. Controlling for firm and time fixed effects, I find a higher long-term debt to asset ratio to be associated with lower capital expenditures and growth in fixed capital post-crisis. This is also true for financially unconstrained firms vis-a-vis pre-crisis. Moreover, firms with a higher share of long-term debt after the crisis appear to have a greater likelihood of repurchasing shares and larger dollar payouts to equity holders. The evidence points to the fact that any loosening in financial constraints as a result of monetary policy actions has had an impact on firms' capital structure and not real investment.

Inside Debt and the Security Issuance Decision

We examine the effect of inside debt (executive pension plans and deferred compensation) on the security issuance decision. Inside debt is an unfunded and unsecured firm liability that exposes the executive to the same risk of loss in insolvency as unsecured corporate debt. Agency theory predicts that inside debt aligns the interests of managers and debtholders and reduces managerial risk-taking (Jensen and Meckling, 1976). Consistent with theory, we find that CEOs with large inside debt holdings are more likely to issue equity than debt, and, as a result, un-lever capital structure. The results are robust to the tests of endogeneity, alternative proxies for CEO inside debt holdings, CEO horizon effect, and CFO incentives.