Higher Credit Spreads Research Articles

Volatility feedback and dealership position: Evidence from the CDS Index, Corporate Bonds, and Government Bonds

Our study comprehensively confirms the existence of the volatility feedback effect for corporate bonds and the Credit Default Swap (CDS) indexes. We also find that dealers’ net protection-buying position of the CDS indexes relates to high credit spreads for the CDS indexes and the representative corporate bonds, and this relationship is associated with dealers’ compensation. This study is a pioneer in investigating CDS index swaptions and finding an implied volatility smirk and that hedging activities of dealers’ net positions of the underlying CDS index relate to the swaption premiums.

Underinvestment and optimal capital structure under environmental constraints

We develop a Q-theoretical model for levered firms subject to environmental constraints (regulations). The model highlights the implications of environmental constraints on dynamic investment and optimal capital structure decisions. We find that environmental constraints can lead equityholders to become endogenously risk averse. Moreover, environmental constraints give rise to underinvestment in capital and asset sales, which is attributed to the carbon abatement effect caused by environmental constraints. In addition, firms with environmental constraints use conservative debt for low business risk and choose high leverage for high business risk relative to firms without environmental constraints, which is governed by the trade-off between abatement cost effect and risk-aversion effect caused by environmental constraints. Firms with environmental constraints have high credit spreads. Our theoretical results are consistent with some empirical findings.

Cleansing by tight credit: Rational cycles and endogenous lending standards

Endogenous cycles emerge through the two-way interaction between lending standards and production fundamentals. Lax lending standards in booms lead to low interest rates and high output but the deterioration of future loan quality. Low borrower quality in turn precipitates tight standards: the economy enters a recession with high credit spreads and low output but a gradual improvement in the quality of loans. This eventually triggers a shift back to a boom with lax lending, and the cycle continues. The capitalization of expert investors determines the strength of capital reallocation in recessions. Furthermore, although the constrained efficient economy is often cyclical, it features both a static and a dynamic externality in credit supply, hence differing from the decentralized equilibrium.

Are covered bonds different from securitization bonds? A comparative analysis of credit spreads

AbstractThis study compares credit spreads and pricing determinants of securitization vis‐à‐vis covered bonds. Our analysis reveals that although ratings are the most important pricing determinant for asset‐backed securities (ABS) and mortgage‐backed securities (MBS) investors place relatively more importance on contractual, macroeconomic and banks' characteristics rather than ratings in pricing covered bonds. We find evidence of a mispricing effect in structured finance markets: ABS and MBS have higher credit spreads than similarly rated public‐covered bonds and mortgage‐covered bonds and security prices reflect information beyond credit ratings. We find no evidence of borrowing costs affecting banks' choice between securitization and covered bonds.

Moral hazard, debt overhang and capital structure

This paper investigates the impact of managerial moral hazard on the debt overhang of a firm by constructing a contingent claims model in which the manager faces costly effort. Using a calibrated capital structure model, we show that the costs of debt overhang become more serious in the presence of managerial moral hazard. Such costs even account for more than half of the total agency costs at a high level of cash flow. Moreover, in contrast to the results of Hackbarth and Mauer (2012), our model predicts a U-shaped relationship between the leverage ratio and investment opportunities of a firm, which is caused by managers’ moral hazard. Finally, by considering this moral hazard, we also show the coexistence of low leverage ratios and high credit spreads, which explains the phenomenon of “low debt levels and high credit spreads” observed in practice.

Corporate Bankruptcy and Directors’ Reputation: An Empirical Analysis of the Effects on Public Debt Contracts

This article investigates the link between board members’ past professional experiences and the terms and conditions of the debt contracts of their current firms. In particular, we examine whether directors’ past bankruptcy experience affects the pricing and nonpricing terms of public debt contracts. Using a sample of 8,142 bond issues in the United States in the period 1995 to 2015, we document higher credit spreads and smaller bond sizes for firms with such directors, suggesting that bondholders are concerned about past bankruptcy experience. Our results remain robust to different model specifications. This effect is moderated for bankruptcies that are likely driven by macroeconomic shocks such as the dotcom bubble and the global financial crisis. We also show that our findings are not explained by bond issuers with an elevated risk of default and seem instead to be driven by directors serving on key monitoring committees, indicating that prior bankruptcy experience raises concerns about the company’s corporate governance. Finally, mediation analysis offers some evidence of a limited negative indirect effect of prior bankruptcy experience on the terms of debt contracts through the firm’s financial and investment policies. Overall, our findings suggest that lenders incorporate information about past professional experiences of directors into public debt contracting.

Optimal Book-Value Debt Ratio

When a firm has a target capital structure, it is usually in a book-value term rather than a market-value one as normally assumed in standard finance textbooks. This article provides a systematic approach to determine the optimal book-value debt ratio. The proposed method balances both the tax benefit of debt and its associated bankruptcy cost and more importantly incorporates the aims to maintain a good credit rating, financial robustness in times of adverse shocks, and financial flexibility to seize good investment opportunities. In terms of methodology, our model incorporates the tax benefit of debt in the form of lower cost of capital, whereas the expected bankruptcy cost is reflected in a higher credit spread. We adjust the Hamada equation to take default risk into account by applying the method suggested by Cohen when adjusting the cost of equity as a debt ratio changes. The model is calibrated to data from the U.S. non-financial firms. It provides predictions concerning the effects of key variables such as profitability and growth. Our model reveals a negative relationship between growth opportunities and market debt ratios but no clear directional relationship with book debt ratios. In addition, our model points to the negative (positive) relationship between profitability and market (book) debt ratio. Interestingly, the two debt ratios move in the opposite directions. These predictions have support from existing empirical literature.

Sustainable Factor Investing: Where Doing Well Meets Doing Good

This paper investigates the impact of ESG integration on systematic factors in Australia. While excluding non-rated stocks leads to inferior performance, simultaneously exploiting ESG scores with past returns significantly improves the Sharpe ratio and the crash risk profile of the momentum strategy. Such outperformance is more pronounced during periods of slow growth, high inflation and high credit-spreads. The improved performance, which originates from the governance dimension, can be explained by sector tilts driven by ESG integration. Overall, our findings suggest that sustainable factor investing not only allows asset-owners to include their ethical preferences while offering strong potential for wealth generation, but also provides asset managers with the opportunity to mitigate risk.

Sustainable factor investing: Where doing well meets doing good

This paper investigates the impact of ESG integration on systematic factors in Australia. While excluding non-rated stocks leads to inferior performance, simultaneously exploiting ESG scores with past returns significantly improves the Sharpe ratio and the crash risk profile of the momentum strategy. Such outperformance is more pronounced during periods of slow growth, high inflation and high credit-spreads. The improved performance, which originates from the governance dimension, can be explained by sector tilts driven by ESG integration. Overall, our findings suggest that sustainable factor investing not only allows asset-owners to include their ethical preferences while offering strong potential for wealth generation, but also provides asset managers with the opportunity to mitigate risk.

Credit Spreads, Rating Downgrades, and Downside Performance: A Market-Informed Approach to Monitoring Credit Risk

This paper studies the differential credit risks embedded in the cross-section of credit spreads. Using corporate bond data from 1999 to 2018, we find that credit spreads relative to those of peers — defined as bonds with the same stated credit rating — contain reliable information about future bond performance and credit migration. Bonds with substantially higher credit spreads relative to those of their peers have higher rates of future downgrades. Using the midpoint between the peer spread curve and the next-lower-rated spread curve as a threshold, we observe that the downgrade frequency in the next three to 12 months is three to four times higher, on average, for bonds above the midpoint compared to those below. We also find that bonds with considerably wider credit spreads behave more in line with bonds with lower credit ratings in terms of average return, volatility, and downside performance. Our results suggest that complementing stated credit ratings with real-time market price data can improve credit risk monitoring.

A comparative analysis of ex ante credit spreads: Structured finance versus straight debt finance

This paper examines the pricing of structured finance (SF) – asset-backed securities (ABS), mortgage-backed securities (MBS), and collateralized debt obligations (CDO) – and straight debt finance transactions. Using a cross-section of 24,525 European bonds issued by financial and nonfinancial firms in the 2000–2016 period, we show that although ratings are the most important pricing determinant for SF and corporate bonds (CB) at issuance, investors rely on other contractual, macroeconomic, and firms’ characteristics beyond these ratings. We find that CDO tranches have, on average, higher credit spreads than similarly rated CB, while investors are not compensated for facing higher systematic risk components in relation to investment-grade ABS and MBS. Our results also support the hypothesis of SF transactions as mechanisms of reducing funding costs: SF transactions’ weighted average spread is lower than that of comparable CB and originating firms’ creditworthiness does not deteriorate when compared to a sample of matched firms.

Rational Sentiments and Economic Cycles

We propose a rational model of endogenous cycles generated by the two-way interaction between credit market sentiments and real outcomes. Sentiments are high when most lenders optimally choose lax lending standards. This leads to low interest rates and high output growth, but also to the deterioration of future credit application quality. When the quality is sufficiently low, lenders endogenously switch to tight standards, i.e. sentiments become low. This implies high credit spreads and low output, but a gradual improvement in the quality of applications, which eventually triggers a shift back to lax lending standards and the cycle continues. The equilibrium cycle might feature a long boom, a lengthy recovery, or a double-dip recession. It is generically different from the optimal cycle as atomistic lenders ignore their effect on the composition of the pool of borrowers. Carefully chosen macro-prudential or countercyclical monetary policy often improves the decentralized equilibrium cycle.

Using commercial mortgage loans to assess risk and return in the lodging sector

Abstract The purpose of this study is to investigate the risk and return features of the lodging sector using a large sample of 16,898 commercial mortgage loans securitized into commercial mortgage-backed securities (CMBS) in the U.S. between 2010 and 2018. The results of the analysis show significantly lower loan-to-value (LTV), higher debt service coverage ratios (DSCR), and higher credit spreads in the lodging sector than all other commercial property sectors. Additional findings document significantly higher lodging sector capitalization rates and equity dividend rates. Taken together, the results of the study provide strong empirical support for the positive relationship between risk and return in the lodging sector. Therefore, investors will require higher returns to compensation them for the additional risk of investing in the lodging sector. The theoretical and practical implications of these results are also discussed.

Assessing Contingent Convertible Bonds for Bank Recapitalization in Nigeria

This study estimates the parameters of credit derivatives, equity derivatives and structural models for bank recapitalisation in Nigeria by employing contingent convertibles (CoCos) and using the Nigeria Treasury Bill rate for 2009 as the risk-free rate, estimated recapitalisation requirements for the banks as at 2009 and relevant banks’ share prices for 2008 and 2009. The study finds the structural approach as the preferred model for CoCo pricing, as it reported the least pricing errors and also builds asset values of the banks from publicly-available quoted stock prices as well as deposit components of bank’s balance sheet information. The study also finds that CoCo bonds are likely to be fully subscribed when issued given the high stock price volatility coupled with high credit spreads in Nigeria. The paper suggests that CoCos could have been issued by the banks to recapitalise themselves without the need for regulatory actions. Therefore, usage of CoCos by banks can reduce the possibility of a bailout with public funds and lessen regulatory actions, if properly implemented, to boost the troubled banks’ capital.

Independent Boards and Bondholder Agency Risk

I use the NYSE/NASD board independence reforms to study the effect of corporate boards on bond contract terms. Firms that transition to independent boards experience significant reductions in the use of payout, financing, and event risk covenants in their bond contracts. This effect is not offset by higher credit spreads. The contracting consequences of the board reforms are more pronounced in Delaware, where state law limits directors’ incentives to favor equity over debt, when firms are more vulnerable to takeovers, and when firms have fewer distracted directors. These results are consistent with the role of independent boards in promoting oversight of managers’ corporate policy choices, thereby reducing bondholders’ agency costs.

Industry Competition, Credit Spreads, and Levered Equity Returns

This paper examines the relation between industry competition, credit spreads, and levered equity returns. I build a quantitative model where firms make investment, financing, and default decisions subject to aggregate and idiosyncratic risk. Firms operate in heterogeneous industries that differ by the intensity of product market competition. Higher competition reduces profit opportunities and increases default risk for debtholders. Equityholders are protected against default risk due to the option value arising from limited liability. In equilibrium, competitive industries are characterized by higher credit spreads, but lower expected equity returns. I find strong empirical support for these predictions across concentration terciles.

What is project finance?

Project finance is the process of financing a specific economic unit that the sponsors create, in which creditors share much of the venture’s business risk and funding is obtained strictly for the project itself. Project finance creates value by reducing the costs of funding, maintaining the sponsors financial flexibility, increasing the leverage ratios, avoiding contamination risk, reducing corporate taxes, improving risk management, and reducing the costs associated with market imperfections. However, project finance transactions are complex undertakings, they have higher costs of borrowing when compared to conventional financing and the negotiation of the financing and operating agreements is time-consuming. In addition to describing the economic motivation for the use of project finance, this paper provides details on project finance characteristics and players, presents the recent trends of the project finance market and provides some statistics in relation to project finance lending activity between 2000 and 2014. Statistical analysis shows that project finance loans arranged for U.S. borrowers have higher credit spreads and upfront fees, and have higher loan size to deal size ratios when compared with loans arranged for borrowers located in W.E. On the contrary, loans closed in the U.S. have a much shorter average maturity and are much less likely to be subject to currency risk and to be closed as term loans.

Risk-Shifting, Equity Risk, and the Distress Puzzle

This paper examines the relationship between financial distress and equity returns. Using strategic action proxies, we find that financial distress is a robust and negative predictor of future stock returns apart from the effect of strategic shareholder actions. This shows that the distress puzzle cannot be fully explained by shareholder strategic actions or shareholder advantages. The distress effect also cannot be explained by traditional risk factors, characteristics, or mispricing. However, the results presented in this paper are consistent with the risk-shifting hypothesis. Three findings support this claim. First, distressed firms tend to overinvest, earn low profits, and exhaust their cash flows. This effect is concentrated in low growth opportunity firms and in hard-to-value firms. Second, distress effects are concentrated in firms without credit ratings or convertible debt and in which CEOs have equity holdings. Third, distressed firms tend to have high credit spreads.

Institutional Differences and International Private Debt Markets: A Test Using Mandatory IFRS Adoption

ABSTRACTInstitutional differences between countries result in additional information risks between borrowers and lenders in cross‐border private loans. This study examines the effect of these information risks on the structure of optimal debt contracts in international (cross‐border) versus domestic private debt markets. Using mandatory IFRS adoption as an indicator for institutional changes that reduced differences between countries, I compare attributes of international versus domestic loans before and after IFRS adoption. I find that, in the pre‐IFRS period, international loans are associated with a higher credit spread, a weaker relationship between the bank and the borrower, a more diffuse loan syndicate, and less reliance on accounting‐based covenants than domestic loans. These results are consistent with incremental information risks in international debt markets that make it more costly for lenders to screen and monitor borrower credit quality, resulting in a more arm's‐length relationship between borrowers and lenders. Many of these associations attenuate after IFRS adoption, suggesting that the pre‐IFRS differences in contract terms are driven by incremental information risks related to institutional differences between countries. My findings imply that incremental information risks result in a different optimal contract in international debt contracts compared to domestic debt contracts.

A Macroeconomic Model with Financially Constrained Producers and Intermediaries

We evaluate the quantitative effects of macroprudential policy. To do so, we solve a general equilibrium model with three types of agents and a government. Borrower-entrepreneurs produce output financed with long-term debt issued by financial intermediaries, subject to a leverage constraint. Intermediaries fund these loans combining deposits and their own equity, and are subject to a regulatory capital constraint. Savers provide funding to banks and to the government. Both entrepreneurs and banks make optimal default decisions. The government issues debt to finance budget deficits and to pay for bank rescue operations. We solve for macroeconomic quantities, the price of capital, the yield on safe bonds, and the credit spread. We study how financial and non-financial recessions differ, show that high credit spreads forecasts future declines in economic activity, and study macro-prudential policies. Policies that limit corporate leverage and financial leverage reduce welfare. Their benefits for financial and macro-economic stability are outweighed by the costs from a smaller-sized economy. The two types of macroprudential policies have different implications for the wealth distribution.