A Gap-filling Theory of Corporate Debt Maturity Choice

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday January 29, 2010 at 9:06 am
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Editor’s Note: This post comes to us from Robin Greenwood, Associate Professor of Business Administration at Harvard Business School, Samuel Hanson, Ph.D. Candidate in Business Economics at Harvard University, and Jeremy Stein, Professor of Economics at Harvard University.

In our paper A Gap-filling Theory of Corporate Debt Maturity Choice, which was recently accepted for publication in the Journal of Finance, we develop a new theory to explain time-variation in corporate maturity choice. As in BGW (2003), our theory allows for predictability in bond market returns and has the feature that corporate issuers tend to benefit from this predictability – ­i.e., they use short-term debt more heavily when its expected returns are lower than the expected returns on long-term debt. Crucially, however, we do not assume any forecasting advantage for corporate issuers: they have no special ability to predict future returns, or to recognize sentiment shocks. Instead, the key comparative advantage that corporate issuers have relative to other players in our model is an advantage in macro liquidity provision.

More specifically, our theory has the following ingredients. First, the bond market is partially segmented, in that there are some important classes of investors who have a preference for investing at given maturities. These investors might include, for instance, pension funds, which, based on the structure of their liabilities, have a natural demand for long-term assets. Second, there are shocks to the supply of long- and short-term bonds that are large relative to the stock of available arbitrage capital. In our empirical work, we associate these supply shocks with changes in the maturity structure of U.S. government debt. And third, there are arbitrageurs (e.g., broker-dealers and, more recently, hedge funds) who attempt to enforce the expectations hypothesis, but­ – given limited capital and the undiversifiable nature of the required trade­ – do so incompletely, leaving behind some residual predictability in bond returns.

Taken together, these three ingredients imply that bond market predictability takes a particular form: when the supply of long-term Treasuries goes up relative to the supply of short-term Treasuries, long-term Treasuries must offer a greater expected return. This idea goes back to Modigliani and Sutch (1966a, 1966b) and is developed formally in recent work by Vayanos and Vila (2009), as well as by Greenwood and Vayanos (2008), who provide supporting evidence. Building on these papers, we add one further ingredient to the story, namely, corporate issuers, who have to raise a fixed amount of total debt financing and who must choose whether to issue at short or long maturities. These corporate issuers have no forecasting edge over the arbitrageurs, since government-induced supply shocks are perfectly observable to both types of agents. Rather, what distinguishes the corporate issuers from the arbitrageurs is that they have a potentially greater capacity to absorb the supply shocks. In other words, corporate issuers have a comparative advantage in the provision of this particular kind of liquidity.

The source of this comparative advantage flows from the logic of the Modigliani-Miller (1958) theorem. To see why, imagine a world in which there are no taxes or costs of financial distress, so that firms are indifferent as to the maturity structure of their debt. If we now introduce into this world even tiny differences in the expected returns to short- and long-term debt, firms will respond very elastically by varying the maturity of what they issue. Indeed, in the limit, they will do so until the point where any expected return differentials are eliminated. In a more realistic setting, firms are likely to have well-defined preferences over their maturity structures, for the reasons alluded to above, and will view it as costly to deviate from their maturity targets. Nevertheless, to the extent that these costs are modest – ­i.e., to the extent that the objective function is flat in the neighborhood of the target – ­patterns of corporate debt issuance will still respond elastically to differences in expected returns, though no longer to the point of completely eliminating these return differences.

In what follows, we develop this theory with a simple model that embeds the limited arbitrage logic of Vayanos and Vila (2009) and Greenwood and Vayanos (2008), and that adds a rudimentary corporate sector. We then go on to test four broad implications of the theory:

  • 1. Gap filling by corporate issuers: First and foremost, our theory predicts that corporate issuance will fill in the supply gaps created by changes in government financing patterns. When the government issues more long-term debt, firms should respond by issuing more short-term debt, and vice-versa. Consistent with this prediction, we document a strong negative correlation between the maturities of government and corporate debt. A rough estimate is that the corporate sector fills 30% to 40% of the gap created by a shock to government debt maturity. This result holds in a battery of specifications that: i) use different measures of corporate debt issuance; ii) control for contemporaneous interest rate conditions, credit spreads, and macroeconomic variables; and iii) take into account the dynamics of corporate and government issuance.
  • 2. Time-series variation in gap filling: If we allow for time-series variation in the relative sizes of the government and corporate debt markets, our theory makes an additional prediction: when the government’s share of total debt is larger, gap-filling behavior by firms will be more pronounced, because larger supply shocks imply a larger reward for liquidity provision. This prediction is also borne out in the data.
  • 3. The cross-section of gap filling: At a micro level, our theory further implies that those firms with the smallest costs of deviating from their maturity targets will be the most aggressive gap fillers. To operationalize this hypothesis, we observe that a firm with a strong balance sheet (a firm that is relatively unconstrained in its investment behavior) is less likely to pay a price if it deviates from its maturity target, thereby taking on, for example, more interest rate or refinancing risk, than a firm with a weak balance sheet. Thus, we would expect firms with stronger balance sheets to have maturity choices that respond more elastically to changes in the structure of government debt. Using a variety of measures of balance sheet strength, we confirm this prediction.
  • 4. The origin of corporate market timing ability: Our theory suggests that corporate actions can be informative because they are a mirror of government supply shocks, which in turn are the primitive drivers of expected returns. Consistent with this, we find that the ability of corporate issuance to forecast bond returns is attenuated if government debt maturity is included in the regression.

 

We believe that our theory sheds new light on market timing phenomena in corporate finance more generally.

The full paper is available for download here.

 

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