Government contracts and US bond yield spreads: A study on costs and benefits of materialized political connections

In a 1991–2013 sample of bonds issued by US public firms, we find that the cost of debt (yield spread relative to comparable Treasuries) of suppliers to government agencies is contingent on the strategic importance of the supplier's industry. The yield spreads for strategically unimportant government suppliers are higher than for firms that are not government suppliers. If government contracts serve as tangible evidence of political connections, these higher yield spreads indicate that weaker corporate governance as a cost of political connections outweighs the benefits of said connections. For the subsample of government suppliers from strategically important industries, where the benefits of implicit bailout guarantees and revenue stability outweigh the corporate governance problems, the cost of debt is lower than for firms that are not government suppliers. The higher (lower) cost of debt for strategically unimportant (strategically important) suppliers is confined to contracting with the federal government. Our findings are robust to alternative variable and sample specifications, and to endogeneity concerns.     

U.S. POLITICAL CORRUPTION AND LOAN PRICING

Using U.S. Department of Justice data on state-level political corruption, we find that banks charge higher loan spreads (all-in-drawn spreads) to firms in states with higher corruption and that these effects are more pronounced for firms facing financial constraints but less pronounced for firms experiencing greater external monitoring. These results are robust to additional controls, alternative corruption measures, a measure of the lack of oversight of lobbyist activities, and the use of instrumental variables. Overall, our findings are consistent with the harmful corruption environment hypothesis, which states that banks charge higher loan spreads to firms in states with greater political corruption environments as these firms are susceptible to making suboptimal financial decisions to fend off rent-seeking behavior.     

The political determinants of sovereign bond yield spreads

This paper analyzes the political determinants of sovereign bond yield spreads using data for 27 emerging markets in the period 1996 to 2009. I find strong evidence that countries with parliamentary systems (as opposed to presidential regimes) and a low quality of governance face higher sovereign yield spreads, while the degree of democracy and elections play no significant role. A higher degree of political stability and the power to implement austerity measures significantly reduce sovereign yield spreads particularly in autocratic regimes, while no significant effect is detected for democratic countries. Overall, political determinants have a more pronounced impact on sovereign bond yield spreads in autocratic and closed regimes than in democratic and open countries.     

The Impact of Legal and Political Institutions on Equity Trading Costs: A Cross-Country Analysis

We conjecture that macro-level institutions affect equity tradingcosts through their impact on information risk and investorparticipation. In a study of trading costs for 412 NYSE-listedAmerican Depository Receipts (ADRs) from 44 countries, we findthat, after controlling for firm-level determinants of tradingcosts, effective spreads and price impact of trades are significantlylower for stocks from countries with better ratings for judicialefficiency, accounting standards, and political stability. Tradingcosts are significantly higher for stocks from French civillaw countries than from common law countries. Overall, we concludethat improvements in legal and political institutions will lowerthe cost of liquidity in financial markets.     

Corporate philanthropy in a politically uncertain environment: does it bring tangible benefits to a firm? Evidence from China

We examine the impact of political uncertainty on a firm’s corporate philanthropy (CP) contribution and the associated direct tangible benefits of CP to a firm. Specifically, we examine two testable hypotheses. (1) When facing political uncertainty, a firm makes more CP, and (2) after a firm makes CP contributions during a period of uncertainty, it will obtain future tangible benefits. Using a sample of Chinese listed firms, we document that a firm, on average, increases its CP significantly during a period of political uncertainty (e.g. when there is a new local communist party secretary or mayor). In addition, we report that, on average, a firm’s donation in year t is positively correlated with its amount of government subsidies, corporate income tax reduction, and short- and long-term bank loan amounts in year t?+?1. The findings are robust compared to those of placebo tests and fixed effect models, as well as when using an alternative measure of political uncertainty. We observe that the results are more pronounced among non-state-owned enterprises (non-SOEs) than those among SOEs, corroborating the notion that during a period of political uncertainty, non-SOEs are more willing to build political connections with new city leaders through CP than are SOEs.     

Emerging market bond spreads: The role of global and domestic factors from 2002 to 2011

We address the importance of external versus domestic conditions in determining emerging market bond (EMBI) spreads. Using principal components, we derive a measure of global risk aversion, which is shown to have a significant and, when interacted with a country's foreign debt to GNI ratio, nonlinear effect on these bond spreads. Our model, estimated using Pooled Mean Group techniques, which also incorporates country-specific variables (foreign debt, fiscal policy, debt servicing and political risk), is able to track developments in emerging market bond spreads over the period May 2002 to October 2011 quite well. From mid 2002 to mid 2007, the model suggests that just over two thirds of the decline in these spreads on average reflected improved fundamentals, with the rest due to easy credit conditions. During the 2008 crisis, virtually all of the run-up in emerging market spreads was due to the large increase in our measure of risk aversion. A model of the measure of risk aversion is also estimated, which identifies as its key drivers, the outlook for growth in the major OECD and large non-OECD economies as well as US credit supply conditions.     

Political rights and the cost of debt

We examine the impact of country-level political rights on the cost of debt for corporate bonds issued by firms incorporated in 39 countries. Similar to, but separate from, the relation for creditor rights, greater political rights are associated with lower yield spreads. A one standard deviation increase in political rights is associated with an 18.6% decline in bond spreads. We find evidence that political and legal institutions are substitutes; marginal improvements in political rights produce greater reductions in the cost of debt for firms from countries with weaker creditor rights. We examine potential factors through which political rights may affect the cost of debt and find that greater freedom of the press provides an important channel for reducing bond risks. Moreover, debt of firms with cross-listed equity trades at a premium in U.S. markets, but this relation appears to be more consistent with improved visibility than with bonding effects.     

Fear or fundamentals? Heterogeneous beliefs in the European sovereign CDS market

This paper proposes a model for credit default swap (CDS) spreads under heterogeneous expectations to explain the escalation in sovereign European CDS spreads and the widening variations across European sovereigns following the Global Financial Crisis (GFC). In our model, investors believe that sovereign CDS spreads are determined by country-specific fundamentals and momentum. By estimating the model we find evidence that, while some of the recent movements in sovereign CDS spreads can be explained by deteriorating fundamentals for core European Union (EU) countries, momentum has also played a destabilizing role since the GFC in all sovereign credit markets studied.     

Politically Connected Governments

This paper examines the consequences of powerful political connections for local governments. We find that governments located within the constituencies of, and thus connected to, powerful congressional members reduce their stewardship over public resources. Using plausibly exogenous declines in the power of congressional representation, we show that the effect is causal. To better understand why connected local governments can reduce stewardship, we study electoral characteristics. Our findings suggest that the increased resources that come with powerful congressional representation allow local-government officials to reduce stewardship without material adverse effects on their reelection prospects. In sum, we provide evidence of a cost of political connections: they weaken local governments' incentives to act in a socially optimal manner.     

The pricing of accruals quality in credit default swap spreads

We examine the association between accounting information risk, measured with accruals quality (AQ), and credit spreads, primarily measured with credit default swap (CDS) spreads. Theoretically, AQ measures the precision with which accruals map into cash flows. Better AQ implies a more precise estimate of future cash flows and, we predict, a reduction in credit spreads due to resulting lower uncertainty regarding the ability to meet debt interest and principal payments. In support of this hypothesis, we find a negative relationship between AQ and CDS spreads whereby better AQ is associated with lower CDS spreads. Additionally, we investigate the components of total AQ and find that innate AQ is more strongly associated with CDS spreads than is discretionary AQ. We further show that AQ moderates the market's pricing of earnings: the relationship between earnings and CDS spreads weakens as AQ worsens. Together, our results indicate that accounting information risk is priced in credit spreads and that the CDS market responds not only to the level of earnings, but the quality thereof as well.     

Firm culture and internal control system

The corporate culture within firms is a significant concern for regulators, shareholders and other stakeholders. Drawing on a large sample of US firms, we use the political preferences of the top management team (TMT) to proxy for a firm's culture and examine whether it influences the decision to implement an effective internal control system (ICS) and whether the ICS plays a mediating role between the culture created by the TMT and financial reporting quality. We find that a Republican-leaning TMT with a more conservative ideology is associated with a more effective internal control system. In addition, the TMT's political preferences affect financial reporting quality, both directly and indirectly, via the internal control system. A range of robustness tests reinforces our main findings.     

Corporate Lobbying,Visibility and Accounting Conservatism

In this study, we examine the relationship between a firm's lobbying activities and financial reporting quality using a US setting where public scrutiny of corporate political activities is high. More importantly, we examine whether and how a firm's visibility shapes the relationship between its corporate lobbying activities and accounting conservatism. Adopting annual lobbying expenditure data to measure firms’ lobbying activities, and using a propensity‐score‐matching methodology to control for differences in firm characteristics between lobbying and non‐lobbying firms, we find a positive relationship between a firm's lobbying intensity and the degree of accounting conservatism in its financial reporting. We further find this positive relationship to be more pronounced in lobbying firms with a higher level of visibility. These results are robust after controlling for a firm's political connections, across various conditional conservatism measures, and across a number of visibility measures including firm size, the number of analysts following the firm, the age of the firm, the number of foreign stock exchanges that the firm is cross‐listed in, and the level of the firm's media coverage. Together, our findings add to the literature on how firms’ political activities shape their accounting practices in general, and accounting conservatism in particular. More importantly, our findings suggest that the heightened public attention paid to political activities in the US yields incentives for firms to be more conservative in their accounting practices.     

Measuring Sovereign Risk: Are CDS Spreads Better than Sovereign Credit Ratings?

Using data for 54 countries over a 12‐year period, we find that the variation in average sovereign ratings in a given year can be explained by average credit default swap (CDS) spreads over the previous three years. In a horse race between CDS spreads and sovereign ratings, we find that CDS spread changes can predict sovereign events, while rating changes cannot. The predictability of CDS spreads is greater when there is disagreement between Moody's and the S&P for a country's rating.     

Information Disclosure and Stock Liquidity: Evidence from Borsa Italiana

This article examines the effect of increased corporate information disclosure on stock liquidity. Using the adoption of International Financial Reporting Standards (IFRS) in Italy as a natural experiment we extend previous work examining the effect on one measure of liquidity—bid‐ask spreads—to others, specifically depth and the price impact of transactions (or effective bid‐ask spreads). Consistent with previous research we find that bid‐ask spreads of stocks decline following the introduction of IFRS, which implies that stock liquidity increases for small traders. However, we also provide evidence that depth at the best quotes declines, which challenges the proposition that liquidity increases for large trades following an increase in disclosure. In additional tests, we find that effective bid‐ask spreads of block trades also decline following the introduction of IFRS. Overall, this evidence confirms that stock liquidity for both small and large trades increases following an increase in corporate information disclosure.     

Political Uncertainty, Financial Crisis and Market Volatility

This paper examines the impact of political uncertainty on financial crises using a panel of 22 emerging markets. By examining political election cycles, we find that eight out of nine of the financial crises happened during the periods of political election and transition. Using a combination of probit and switching regression analysis, we find that there is a significant relationship between political election and financial crisis after controlling for differences in economic and financial conditions. We observe increased market volatility during political election and transition periods. Our results suggest that political uncertainty could be a major contributing factor to financial crisis. Thus, politics does matter in emerging markets. Since the odds of financial crisis tend to be much larger during the political election periods, institutional investors should take that into account when making emerging market investment during those time periods.     

Doorsteps Toward Political and Economic Openness: Testing the North-Wallis-Weingast Transition Framework

In this paper, we test the theoretical framework developed by North, Wallis, and Weingast (2009), who posit that limited-access societies need to meet three doorstep conditions before they can transit into open-access societies: (1) establishment of rule of law among elites, (2) adoption of perpetually existing organizations, and (3) political control of the military. We identify indicators reflecting these doorsteps and econometrically test their relationships with specific political and economic variables. We broadly confirm the logic behind the doorsteps as necessary conditions in the transition to open-access societies. The doorsteps influence economic and political processes, as well as each other, with varying intensities.     

Do sovereign credit default swaps represent a clean measure of sovereign default risk? A factor model approach

In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.     

Understanding the term structure of credit default swap spreads

The shape of the term structure of credit default swap (CDS) spreads displays large variations over time and across firms. Consistent with the predictions of structural models of credit risk, we find that the slope of CDS spread term structure increases with firm leverage and volatility, but decreases with the level and the slope of the Treasury yield curve. However, these variables together have rather limited explanatory power for CDS slope and there is a significant common component in the regression residuals. In addition, we find that CDS slope predicts future changes in the CDS spreads, even after controlling for the contemporaneous variables that determine changes in the CDS spreads according to the structural models. Our results suggest that while structural models are qualitatively useful for understanding the shape of credit term structure, there are missing factors that importantly affect the term structure of CDS spreads.     

The effect of interest rate volatility and equity volatility on corporate bond yield spreads: A comparison of noncallables and callables

This research investigates the impact of interest rate volatility upon corporate bond yield spreads. We first consider the impact of interest rate volatility upon noncallable bond spreads. Because greater interest rate volatility likely increases the volatility of the firm's debt, we hypothesize that the relation will be positive. Given that we do find a positive relation, we thus investigate whether the positive effect of interest rate volatility on yield spreads is stronger or weaker for callable bonds. We find that the effect is weaker for callable bonds. This result indicates that there is a negative relation between default spreads and call spreads, which is consistent with the theory of Acharya and Carpenter (2002), but in contrast to the theory of King (2002). Furthermore, our results for the relationship between equity volatility and yield spread tend to support Acharya and Carpenter (2002) more than King (2002).     

Insider trading law enforcement and gross spreads of ADR IPOs

Using American Depositary Receipt (ADR) IPOs from 34 countries during 1980-2004, we find that, on average, the enforcement of insider trading laws reduces the underwriter gross spread by 49-61 basis points, which is about 10-12% of the average gross spread for ADR IPOs. This relation is present regardless of whether issuers have a prior listing or whether issuers are from developed or emerging markets. The association becomes stronger for ADRs underwritten by less prestigious underwriters and for issuers that are involved in privatization. The political institutions in the issuers’ home markets also affect gross spreads.