Development costs capitalization and debt financing

This study investigates debt market effects of research and development (R&D) costs capitalization, using a global sample of public bonds and private syndicated loans issued by public non‐financial firms. Firstly, we show that firms capitalize larger amounts of R&D in a year when they exhibit a propensity for issuing bonds, rather than borrowing funds privately from the syndicated loan market, in the subsequent year. Secondly, we provide evidence that capitalized R&D investments reduce the cost of debt. We infer that debt market participants are able to identify firms’ motives for R&D capitalization, as we find a reduction in the cost of debt only for those firms that do not show indications of employing R&D capitalization for earnings management reasons. Indeed, only for this sub‐sample of firms, the amount of capitalized R&D contributes positively to future earnings. We confirm that R&D capitalization is positively associated with audit fees and thus can be deemed to be a signaling device. Lastly, we find that it is the amount of R&D a firm is expected to capitalize and not the discretionary counterparts, which facilitates a firm's access to public debt markets, reduces bond and syndicated loan prices, and contributes to future benefits.     

Managerial effect or firm effect: Evidence from the private debt market

This paper provides evidence that the managerial effect is a key determinant of firms’ cost of capital, in the context of private debt contracting. Applying the novel empirical method developed by an earlier study to a large sample that tracks the job movement of top managers, we find that the managerial effect is a critical and significant factor that explains a large part of the variation in loan contract terms more accurately than firm fixed effects. Additional evidence shows that banks “follow” managers when they change jobs and offer loan contracts with preferential terms to their new firms.     

Compliance with pension‐related mandatory disclosures and debt financing

Using hand‐collected data on the level of pension‐related mandatory disclosures required by International Accounting Standard 19 Employee Benefits, we test whether compliance levels with these disclosures convey information that affects firms’ access to the public instead of the private debt market, as well as the cost of their new debt issues. We document a higher tendency to access the public debt market for firms with higher levels of pension‐related disclosure. Furthermore, we find that firms with higher levels of pension‐related disclosure enjoy a lower cost in terms of issuance of public debt, but not a lower cost for private debt issues. Thus, the benefits of disclosure in reducing information risk are only realisable when creditors rely heavily on financial statements in their decision making, due to the limited access to private information. Additional tests reveal that high compliance levels effectively mitigate the negative effect of pension deficits on the cost of public debt. These findings provide novel evidence in the extant literature on the role of mandatory (and, in particular, pension‐related) disclosures on firms’ debt financing. They also have important policy implications.     

Does the Riskiness of R&D Outweigh Its Benefits? The Perspective of US Private Lenders

We investigate the relationship between R&D investments and loan spread. Prior research documents that R&D is associated with greater future benefits and risks, suggesting that the valuation of R&D depends on a tradeoff between the two. Some research finds that bondholders consider that the benefits of R&D outweigh its risks: R&D is negatively associated with bond yields. This is surprising given that debt holders are more concerned about downside risk due to asymmetric payoffs. Using data on private debt from the US, we find an overall positive association between loan spread and R&D intensity, suggesting that the riskiness of R&D appears to outweigh its benefits for private lenders. Furthermore, an asymmetric payoff structure implies that the risks of R&D for lenders increase with default risk. Consistent with this argument, we find a positive association between R&D and loan spread for firms that are smaller, with high default‐risk ratings, unrated (no public debt), or in industries with weaker legal protection. Unrated firms are in the most R&D‐intensive group and make up nearly 60% of the firms with private debt. Consequently, studies that exclude unrated firms are likely to present an incomplete picture of the perspective of debt holders on R&D.     

Loan loss provisions and income smoothing – Do shareholders matter?

In this paper, we aim to analyse the role of shareholders in the creation of discretionary loan loss provisions (LLP) and the use of LLP in income smoothing. Using a sample of over 200 Central European banks, we demonstrate that LLP and income smoothing of foreign-owned banks and state-owned banks differ from those of domestic private banks. Foreign and state banks create higher discretionary LLP than private domestic banks. Foreign banks use these LLP to perform discretionary income smoothing, while state banks, in general, do not smooth income. Higher LLP of foreign banks are observed in banks with low asset quality and high profitability. Foreign banks with low profitability that operate in volatile economic environments do not create higher discretionary LLP than domestic private banks. This implies that their risk is not lower than that of locally owned banks, at least on the credit side. In the aftermath of the financial crisis, both foreign and state banks have become more prudent than domestic private banks, and their discretionary LLP are higher. Overall, we provide evidence that foreign and government ownership affect LLP policy in banks. This complements existing results on the differences in loan cyclicality and default risk between foreign, state and domestic private banks.     

Managerial Incentives for Income Smoothing Through Bank Loan Loss Provisions

We examine alternative underlying motives of bank managers in using loan loss provisions (LLP) to smooth reported income. Based on the analytical results of Fudenberg and Tirole (1995), we predict that for banks with good (poor) current performance and expected poor (good) future performance, managers will save income for (borrow income from) the future by reducing (increasing) current income through LLP. We also analyze three additional variables that could explain cross-sectional differences in the level of income smoothing. Our empirical analysis provides support for our predictions. The difference in LLP between the two groups of banks is positive as hypothesized, indicating that bank managers do save earnings through LLP in good times and borrow earnings using LLP in bad times. Similar results are obtained for analysis using discretionary LLP. When bank managers are saving earnings for the future, we provide evidence that the need to obtain external financing is an important additional variable in explaining cross-sectional differences in the extent of income smoothing. Furthermore, whether or not a bank is well capitalized is also weakly significant in explaining cross-sectional differences in income smoothing.     

Call it good,bad or no news? The valuation effect of debt issues

Studies investigating market reactions to changes in capital structure aim to find the impact of private information conveyed. However, these studies ignore that financial decisions are not made randomly but are conditional on managers’ private information. Using a sample of U.S. leverage‐increasing public companies with public long‐term debt offerings, we find that debt offerings convey no new information to the markets after considering the conditionality of decisions. We also show that results can be biased if the deterministic role played by private information ex ante is omitted, which may explain the conflicting valuation evidence found in the literature.     

U.S. leveraged loan and debt markets: Implications for optimal portfolio and hedging

This paper offers fresh empirical evidence on the relationship between leverage loans and US debt markets by investigating the distributional predictability and directional predictability between leveraged loans and treasury bonds, fixed income securities and corporate bonds in the U.S economy. We use daily price data from January 2013 to April 2021. First, we analyze the causal relationship between variables by applying non-parametric causality-in-quantiles test and find that quantile causality in variance shows the stronger impact of leverage loan market returns on US debt market returns over the entire quantile range. Second, quantile dependence and directional predictability between leverage loan market and US debt markets are analyzed by applying cross-quantilogram approach and estimated results show the heterogeneous quantile relations from leverage loan market to US debt market. Moreover, the cross-quantile correlation results demonstrate the evidence of negative predictability from leverage loan market to US debt market in low, medium and high quantile range. These evidences are important for US investors and portfolio managers.     

Does the use of tax haven subsidiaries by U.S. multinational corporations affect the cost of bank loans?

This study examines whether the use of tax haven subsidiaries by U.S. multinational corporations (MNCs) is associated with the cost of bank loans. We find that more intensive tax haven subsidiary use by MNCs is positively associated with the cost of bank loans. In cross-sectional analyses, we identify channels through which the positive association between tax haven intensity and bank loan costs is more pronounced, such as a weak information environment, poor corporate governance, high CEO pay-for-performance and corporation-related wealth, and low managerial ability. We also find that intensive tax haven use is positively (negatively) associated with non-price loan contract terms, such as collateralization and financial covenants (loan maturity and general covenants). Our main result holds when public bonds are substituted for bank loans. Finally, additional analysis shows that MNCs with high levels of tax haven intensity are more likely to rely on bank loan financing than on raising debt from the bond market. Overall, this study adds to an emerging body of literature on corporate taxation and debt policy.     

The cost of private debt over the credit cycle

We identify global and regional fluctuations in international private debt flows to emerging and developing countries using data on cross-border loans and international bond issuance over 1993–2009. We use micro-level data on syndicated cross-border loans and international bond placements to estimate the effects of individual borrower characteristics as well as macroeconomic conditions on the cost of foreign borrowing and test whether these effects differ across phases of the lending cycle. First, we find that borrower characteristics associated with lower loan spreads are not necessarily associated with lower bond spreads. Second, we find differential effects of borrower characteristics between cycle phases for loans and bonds separately. Third, we find strong reductions in the cost of debt finance during periods when international debt flows are more than one standard deviation above their mean, but not for expansionary periods, when the growth rate of debt flows is increasing. We also find that higher trade ratios in the borrower's home country raise loan spreads more in periods of high credit flows but have no effect on bond spreads. At the same time, borrowers residing in countries with high investment ratios pay lower spreads on bond issuance particularly during periods of high credit flows, but we find no similar effect for loan spreads. Inflation rates, real exchange rates and previous banking crises have small impacts on loan and bond spreads.     

Housing and the Tax System: How Large Are the Distortions in the Euro Area?*

This paper presents new evidence on the impact of the preferential treatment of owner‐occupied housing in the euro area. We find that tax benefits to homeowners reduce the user cost of housing capital by almost 40 per cent compared with the efficient level under neutral taxation. On average, the tax subsidy translates into an excess consumption of housing services equivalent to 7.8 per cent of the value of owner‐occupied housing, or about 30 per cent of financial asset holdings in household portfolios. The bulk of the subsidy stems from undertaxation of the return to home equity, while the average contribution of the tax rebate for mortgage interest payments is driven down by relatively low loan‐to‐value ratios in the data. However, at the margin, the tax‐induced incentive to use mortgage debt to finance the purchase of the main residence is sizeable.     

Managerial ability and debt maturity

We examine whether and how managerial ability affects corporate debt maturity decisions. The demand for shorter maturity debt is expected to be higher in firms operated by high-ability managers, who possess the superior skills needed to anticipate firms’ economic prospects and communicate their private information, thereby alleviating information asymmetry and bolstering their reputation. We document that firms with high ability managers are associated with more short-term debt financing. The effect becomes stronger for firms facing severe information asymmetry problems, unconstrained firms or high quality firms. Supportive evidence is found from the analysis of short- and long-term debt issuance activity. Our findings remain robust to alternative measures of managerial ability and debt maturity choice, and are not driven by omitted variable bias, endogeneity concerns or industry group. Overall, we provide robust evidence that supports the signalling theory for debt maturity structure and contributes to the literatures on managerial ability.     

Is small beautiful? The resilience of small banks during the European debt crisis

We examine the lending behaviour of small and large banks in the Eurozone during the sovereign debt crisis. Relative to large banks, small banks are less pro-cyclical in that they exhibit more stable lending growth across credit expansion and contraction periods. In peripheral countries, the portfolio rebalancing of small banks towards higher public debt (substitution effect) does not appear to cause a reduction of their lending to the private sector. Instead, the level of public debt seems to provide a liquidity buffer that influences bank-specific loan growth positively (complementarity effect), particularly during market-wide lending contractions. Our findings show that for small peripheral banks the substitution effect found in the literature can coexist with a complementarity effect when public debt grows faster than private loans. Our analysis contributes to the ongoing debate on the regulatory treatment of public debt in banks and supports incentives embedded in new banking regulation that penalise bank size.     

The dynamics of CEO equity vs. inside debt and firm performance

This paper provides new evidence on the comparative dynamic effects of CEO inside debt and equity compensation on firm performance as measured by Tobin’s Q. In contrast to the extant literature, we find significant empirical evidence supporting the classic Jensen and Meckling (1976) premise that managers should receive debt vs. equity compensation in proportion to the capital structure of the firm. We also provide new evidence showing that the effects of the CEO compensation structure on firm performance are dependent on the CEO’s time horizon, as measured by the expected period of employment to retirement. We show that the incremental benefits of equity compensation to performance increase with the CEO’s projected time to retirement. A similar, but insignificant relationship is observed for CEO inside debt compensation. Cash compensation is more beneficial to the firm when concentrated near the end of the CEO’s tenure.     

“De‐risking” Corporate Pension Plans: Options for CFOs

Until the stock market bubble burst in 2000–2002, most CFOs viewed their defined benefit pension plans as profit centers and relatively risk‐free sources of income. Since neither pension assets nor liabilities were reported on corporate balance sheets, and expected returns on pension stocks could be substituted for actual returns when reporting net income, the risks associated with DB plans were masked by GAAP accounting and thus assumed to have no bearing on corporate capital structure. But when stock prices and corporate profits fell together, the risks associated with conventional stock‐heavy pension plans showed up first in reduced pension surpluses (or, in many cases, deficits) and then later in higher required cash contributions and lower reported earnings. As a consequence, today's investors (and rating agencies) are viewing pension and other legacy liabilities as corporate debt, and demands for transparency and increased funding have triggered accounting changes and proposed legislative reforms that will further unmask the economics. This article aims to provide both private‐sector and public‐sector CFOs with suggestions for reducing and controlling the cost of providing for the retirement of their employees. Profitable, tax‐paying companies with DB plans should consider (1) funding any unfunded liabilities (if necessary, by issuing debt) and (2) reducing pension equity and interest rate exposures by shifting some (if not all) pension assets into bonds and defeasing the pension liability (achieving a tax arbitrage in the process). And in cases where the expected costs of maintaining DB plans outweigh the benefits, companies should consider freezing or terminating their plans and switching to a defined contribution (DC) or some form of hybrid plan. The authors also propose similar changes for public pension plans, where underfunding and mismatch problems are greater, less transparent, and in some ways less tractable than those of corporate DB plans.     

Financial Restatements, Cost of Debt and Information Spillover: Evidence From the Secondary Loan Market

Abstract:  In this paper, we investigate the effect of financial restatements on the debt market. Specifically, we focus on the secondary loan market, which has become one of the largest capital markets in the US, and ask the following: (1) whether financial restatements increase restating firm's cost of debt financing and (2) whether the information about restatements arrives at the secondary loan market earlier than at the stock market? Using 176 restatement data, we find significant negative abnormal loan returns and increased bid-ask spreads around restatement announcements. Furthermore, this negative loan market reaction is more pronounced when the restatement is initiated by either the SEC or auditors, and when the primary reason for restatement is related to revenue recognition issues. Additionally, we find restatement information arrives at the secondary loan market earlier than at the equity market, and that such private information quickly flows into the equity market. We also show that stock prices begin to decline approximately 30 days prior to the restatement announcements for firms with traded loans. However, we do not find such informational leakage for firms without traded loans. Collectively, the results of this paper suggest: (1) increased cost of debt financing after restatements and (2) superior informational efficiency of the secondary loan market to the stock market.     

Do banks care about analysts' forecasts when designing loan contracts?

We investigate whether banks rely on the information content in equity analysts’ annual earnings forecasts when assessing the risk of potential borrowers. While a long literature finds that analysts provide useful information to market participants, it is not clear that banks, which have access to privileged information, would benefit from publicly available analysts’ forecasts. If, however, banks do rely on this information, then more precise private information in earnings forecasts may inform banks. We focus our analysis on the requirement of collateral because it is a direct measure of default risk, whereas other loan terms such as interest spread and debt covenants can also protect against other risks, such as asset misappropriation. The direct link between collateral and default risk allows us to examine whether information from analysts is relevant to banks when designing loan contracts. Consistent with our predictions, we find that higher precision of the private information in analysts’ earnings forecasts is associated with a lower likelihood of requiring collateral, and this effect is larger when a borrower does not have a prior relationship with the lender or their accounting or credit quality is low. We also find that this association disappears after the implementation of Regulation FD, consistent with this regulation reducing analysts’ access to private information.     

Default, insurance, and debt over the life-cycle

The widespread use of debt and default suggests that unsecured credit markets play an important role in consumption smoothing. In this paper, I address two previously unanswered questions. First, how does policy towards debt default affect the evolution of consumption and net worth over the life-cycle? Second, how does debt default policy interact with social insurance over the life-cycle? The findings are as follows. First, US default policy appears “lax”, in the sense that it creates severe credit constraints, especially for the young. Second, eliminating default will lower consumption inequality among the young, but will increase it among the old. Third, social insurance alters default risk and, in turn, loan pricing, and therefore matters for purely intertemporal smoothing.     

Austerity and Private Debt

This study provides empirical evidence that the costs of austerity crucially depend on the level of private indebtedness. In particular, fiscal consolidations lead to severe contractions when implemented in high private‐debt states. Contrary, fiscal consolidations have no significant effect on economic activity when private debt is low. These results are robust to alternative definitions of private‐debt overhang, the composition of fiscal consolidations, and controlling for the state of the business cycle and government debt overhang. I show that deterioration in household balance sheets is important to understand private debt‐dependent effects of austerity.