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The Effects of Bond Supply Uncertainty

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The Effects of Bond Supply Uncertainty on the Leverage of the Firm
Massimo Massa, Ayako Yasuda

In the standard theory of corporate finance, demand conditions in the credit market have been considered as the prominent determinants of the firm’s financing decisions and resulting capital structure of the firm instead of supply conditions. But of late this demand centric approach to understand capital structure have been questioned.

This paper attempts to identify and demonstrate the supply-based bond refinancing risk as a significant determinant of firms’ capital structure.

This paper examines 1) Whether the (supply-based) bond refinancing risk affects the firm’s choice of substitutions between three sources of external financing (bonds, bank loans, and equity).2) How these substitution patterns vary with respect to the degree to which the current investors’ investment and divestment decisions are correlated 3) What is the net effect of the bond refinancing risk on the firm’s leverage and how this effect varies with respect to the correlation in investment patterns among the current bond investors.4) Whether the substitutability between bonds and bank loans varies for issuers that maintain exclusive bank relationships, as opposed to those that do not have exclusive bank relationships.5) Whether the bond refinancing risk affects the firm’s choice debt maturity.

 A measure of turnover for each bond issuer’s investor base in each quarter is constructed using the main data source eMAXX fixed income database by Lipper. The measure is based on the idea that investor base with higher turnover, ceteris paribus, exposes issuers to higher refinancing risk (the risk of not being able to roll over its debt in the next period). Other attributes of issuers’ investor base, such as geographical concentration, home-state bias, and herding propensity, each of which is designed to capture the investors’ propensity to have a credit supply imbalance as a group is also constructed. The rationale is that the higher is the correlation in investment patterns among a given bond’s investors, the more amplified the risk of potential imbalance in credit supply that is induced by a given level of turnover.

The study uses multinomial probit model to examine the firm’s incremental financing decision.

The study finds that high Credit Supply Uncertainty (CSU) leads to lower leverage and lower probability of issuing bonds in the next period. High CSU, on the other hand, increases the firm’s probability of issuing equity and borrowing from banks in the next period. Moreover, these effects are concentrated in firms whose bond investor base is more prone to credit supply imbalances, as measured by investor geographical concentration, herding propensity, and local bond preference. These findings suggest that the financial fragility arising from supply-based (as opposed to demand-based) factors have significant effects on the capital structure of the firm.

While the positive effect of CSU on bank borrowing implies that issuers can substitute away from bonds into bank loans in times of high CSU, this substitution occurs only for firms whose bank relationships are nonexclusive. In contrast, CSU does not affect bank-borrowing decisions of firms with exclusive bank relationships. Together, these findings suggest that investors’ bond supply uncertainty and segmentation of the credit markets (bonds vs. bank loans) are important drivers of corporate financing policy and capital structure even for established firms with access to public bond markets.

Massa, Massimo, Yasuda, Ayako and Zhang, Lei, "The Effects of Bond Supply Uncertainty on the Leverage of the Firm" (August 28, 2007). INSEAD Business School Research Paper No. 2007/57/FIN/ACGRD Available at SSRN: http://ssrn.com/abstract=1021235

 

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