The Composition and Priority of Corporate Debt: Evidence from Fallen Angels
Joshua D. Rauh, Amir Sufi
Large body of theoretical research explores the optimal composition and priority of corporate debt for different types of firms. The primary source of variation in theoretical models that explore optimal debt structure is a firm’s credit quality. Few empirical research have suggested that credit ratings themselves have an important impact on a variety of corporate finance issues, such as firms’ securities prices, debt agreements, financial policy, and investment policy.
This study attempts to examine the debt composition and priority of “fallen angels,” which is defined as firms that have their debt downgraded from investment grade to speculative grade by Moody’s Investors Services. The empirical analysis examines 1) whether firms switch from less monitored to more monitored debt as credit quality deteriorates.2) when the threat of asset substitution is large, do firms place bank debt with a monitoring function senior to all other debt in the capital structure.
The analysis employs a novel data set that records the source, type, and priority of every balance sheet debt instrument for fallen angels from two years before to two years after the downgrade. The sample consists of all non-financial US public firms that are downgraded from investment grade (Baa3 or better) to speculative grade (Ba1 or worse) by Moody’s Investors Services at some point from 1996 through 2005. These data are collected directly from financial footnotes in firms’ annual 10-K SEC filings and supplemented with information on pricing and covenants from three origination-based datasets: Reuters’ LPC’s Dealscan, Mergent’s Fixed Income Securities Database, and Thomson’s SDC Platinum.
Firm fixed effects regression analysis is done relating measures of debt to fiscal year indicators around the downgrade. The dependent variable is either the type or priority of debt scaled by either total assets or total debt capacity, where the latter is defined as total debt plus the unused portion of bank revolvers. For robustness of tests four control variables of market to book ratio, leverage ratio, EBITDA and size are also included.
Before the downgrade, firms maintain large unused bank revolving credit facilities with loose covenants, and have access to discretionary, flexible sources of debt finance such as medium-term notes and commercial paper. After the downgrade, total bank debt capacity declines and the use of Rule 144A private placements and convertibles increases. Firms reduce the use of discretionary bank and non-bank debt financing, and they experience a “spreading” of the capital structure: relative to existing debt, new bank debt is more likely to be secured whereas new issues of private placements are more likely to be subordinated. The incidence of bank covenants and bank financial covenant violations increases sharply after the downgrade.
The findings are consistent with the hypothesis that the composition and priority of corporate debt is structured primarily to encourage bank monitoring. The study finds that banks reduce the size of their claim, obtain first priority, and increase the use of covenants, all of which improve the bank’s incentives to monitor. It is also seen that firms do not switch from non-bank to bank debt following the downgrade. Instead, firms switch from more flexible, discretionary sources of debt finance to less discretionary sources, and switch from bank finance with a primary liquidity role to bank finance with a primary monitoring role.
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