Firms' Off-Balance Sheet and Hybrid Debt Financing: Evidence from Their Book-Tax Reporting Differences

We match large U.S. corporations' tax returns during 1989–2001 to their financial statements to construct a firm‐level proxy of firms' use of off‐balance sheet and hybrid debt financing. We find that firms with less favorable prior‐period Standard & Poor's (S&P) bond ratings or higher leverage ratios in comparison to their industry report greater amounts of interest expense on their tax returns than to investors and creditors on their financial statements. These between‐firm results are consistent with credit‐constrained firms using more structured financing arrangements. Our within‐firm tests also suggest that firms use more structured financing arrangements when they enter into contractual loan agreements that provide incentives to manage debt ratings. Specifically, we find that after controlling for S&P bond rating and industry‐adjusted leverage, our sample firms report greater amounts of interest expenses for tax than for financial statement purposes when they enter into performance pricing contracts that use senior debt rating covenants to set interest rates. Furthermore, we find that the greatest book‐tax reporting changes occur when firms become closer to violating these debt rating covenants. These latter findings are consistent with firms' contractual debt covenants influencing their use of off‐balance sheet and hybrid debt financing.     

Rate regulation of U.S. electric utilities: Does it deter earnings management?

This study is the first broadly-based examination of earnings management within the rate-regulated U.S. electric utility industry. In a three-phase analysis using extant discretionary accrual models in the earnings-management literature, we provide evidence that: (1) on average, rate regulation appears to deter earnings management; (2) relaxing rate regulation (i.e., deregulation) tends to increase the potential for earnings management; and (3) in those situations in which utilities are seeking increased rates from regulators, sufficient accounting latitude exists under GAAP to allow utility management to depress reported earnings. As this last finding may persuade regulators to approve a utility's rate request, triggering increased electricity rates, the potential exists for wealth transfers between “captured” rate-paying customers and shareholders. The study's results also provide for the first time empirical justification for accounting researchers to exclude rate-regulated firms from cross-sectional, inter-industry research designs examining discretionary accruals.     

Effect of credit rating changes on Australian stock returns

We study the impact credit rating revisions have on stock returns of Australian firms rated by Standard & Poor's and Moody's. Our evidence is consistent with that documented in the USA showing that only downgrades contain price‐relevant information. The reaction is most significant when the downgrade: (i) is unanticipated; (ii) is for an unregulated firm; and (iii) reduces the firm's rating by more than one category.     

Can European electric utilities manage asset impairments arising from net zero carbon targets?

This paper develops a framework to assess the ability of electric utilities to sustain the forced impairment of carbon emitting power plants and applies it to the European market. We present a new method to measure asset impairment, for both the company and the industry, based on a database of power plants. We develop a novel framework to analyse a utility's ability to transition by investing in green technology assets through the impact on its credit rating metrics. Finally, we apply our framework to European utilities under scenarios set out by the European Commission to limit global warming by imposing net zero carbon emissions constraints on companies. We conclude that most European utilities have the financial capacity to meet the requirements of net zero carbon emissions under the scenarios with timely action. However, a delay of as little as five years could cause serious financial problems across the sector.     

Debt Crisis Looming? Yes,Corporate Debt Expanded but Don't Panic Over the Prospect of BBB Downgrades

The popular press often tends towards sensationalism and, unfortunately, the supposedly more sober financial press is not always better. It is true that many American companies have taken the opportunity to borrow large sums during recent years when interest rates were close to their all‐time lows. This has also led some media commenters to predict a large number of marginally investment grade debt issues (e.g. BBB rated on the S&P rating scale) will be downgraded to less‐than‐investment‐grade status–or to “junk”–as such bonds are commonly known. Veteran fixed income analyst Martin Fridson takes stock of the situation in mid‐2018. While emphasizing that a bear market is inevitable someday, he advises investors not to panic now. Despite the more apocalyptic scenarios offered by financial commentators making dubious connections between today's corporate bond market and possible future high‐yield events, the aggregate numbers do not add up to an end‐of‐civilization‐as‐we‐know‐it story. Some of the numbers mentioned in financial commentary are at least slightly misleading. The present market lacks the sort of structural weaknesses likely to trigger a major bear cycle in fixed income securities, such as overleveraged buyouts and early‐stage telecoms. While there are some questionable issuers in the market, these are isolated cases, rather than representatives of a vast segment of today's high‐yield universe.     

Debt and Equity Characteristics of Mandatorily Redeemable Preferred Stock

Abstract. This study examines whether mandatorily redeemable preferred stock (MRPS) is priced more like debt or equity by (1) investigating its debt and equity characteristics and (2) specifying conditions under which one characteristic would dominate the other. Based on a sample of 113 nonconvertible MRPS issued during 1970 to 1990, our results are consistent with the view that MRPS has both debt and equity characteristics. The debt (equity) feature is more pronounced among nonutility (utility) issues. Within the utility group, we find high (low) rated MRPS issues to be more debt (equity) like. Our results appear to support current MRPS disclosure rules.     

Contagion Effects of Dividend Reduction or Omission Announcements in the Electric Utility Industry

This study examines the contagion effects of dividend reduction or omission announcements in the electric utility industry. Using a series of ten electric utility dividend announcements covering the period 1979–1991, I analyze differences in contagion reactions across utilities. I find the strength of the contagion reaction is significantly related to utility size, average dividend yield, debt ratio, market‐to‐book ratio, cash flow, and Altman's Z‐score. There is also evidence of a flight to quality, including a preference for utilities operating in more favorable regulatory environments.     

Does Risk Management Add Value? A Survey of the Evidence

The fact that 92% of the world's 500 largest companies recently reported using derivatives suggests that corporate managers believe financial risk management can increase shareholder value. Surveys of finance academics indicate that they too believe that corporate risk management is, on the whole, a valueadding activity. This article provides an overview of almost 30 years of broadbased, stock‐market‐oriented academic studies that address one or more of the following questions:

• ? Are interest rate, exchange rate, and commodity price risks reflected in stock price movements?
• ? Is volatility in corporate earnings and cash flows related in a systematic way to corporate market values?
• ? Is the corporate use of derivatives associated with reduced risk and higher market values?

The answer to the first question, at least in the case of financial institutions and interest rate risk, is a definite yes; all studies with this focus find that the stock returns of financial firms are clearly sensitive to interest rate changes. The stock returns of industrial companies exhibit no pronounced interest rate exposure (at least as a group), but industrial firms with significant cross‐border revenues and costs show considerable sensitivity to exchange rates (although such sensitivity actually appears to be reduced by the size and geographical diversity of the largest multinationals). What's more, the corporate use of derivatives to hedge interest rate and currency exposures appears to be associated with lower sensitivity of stock returns to interest rate and FX changes. But does the resulting reduction in price sensitivity affect value—and, if so, how? Consistent with a widely cited theory that risk management increases value by limiting the corporate “underinvestment problem,” a number of studies show a correlation between lower cash flow volatility and higher corporate investment and market values. The article also cites a small but growing group of studies that show a strong positive association between derivatives use and stock price performance (typically measured using price‐to‐book ratios). But perhaps the nearest the research comes to establishing causality are two studies—one of companies that hedge FX exposures and another of airlines' hedging of fuel costs—that show that, in industries where hedging with derivatives is common, companies that hedge outperform companies that don't.     

The Choice Among Long-Term Financing Instruments for Public Utilities

This study examines the decision of regulated utilities to raise new financing via common stock, debt, or preferred stock offerings. We develop several logit models to test how a set of relevant variables affects the issuing choice. These variables include the level of insider ownership, regulatory climates, measures of aggregate market conditions, bankruptcy risk, deviations from the long-and short-term target ratios, asset composition, etc. In addition, this paper tests whether the cross-sectional level of debt ratio is related to some of these same factors. Our findings indicate that U.S. electric utilities are not influenced by market timing when making a choice among long-term financing instruments. However, our results do show that ownership structure variables, such as the number of directors and officers, seem to have a significant negative influence upon the choice of common stock, thus lending support to Friend and Lang's finding. In addition, capital structure seems to matter for utilities.     

SOME EMPIRICAL EVIDENCE ON THE USE OF FINANCIAL LEASES

In this paper, the impact of certain firm-specific factors on the level of financial leases used by corporations is examined. An industry analysis indicates that firms in certain industries tend to lease more than other firms. A Tobit analysis of the degree to which approximately 600 firms lease assets indicates that certain factors—including the debt ratio, presence of mortgage debt, level of subordinated debt, presence of restrictions on leasing, number of bonds in a firm's capital structure, and the firm's debt rating—are significantly related to the degree of leasing. Other factors, including the firm's tax rate, were not found to be significant, contrary to popular expectations.     

The Effect of Interest Rate Changes on the Common Stock Returns of Financial Institutions

This paper examines the relation between the interest rate sensitivity of common stock returns and the maturity composition of the firm's nominal contracts. Using a sample of actively traded commerical banks and stock savings and loan associations, common stock returns are found to be correlated with interest rate changes. The co-movement of stock returns and interest rate changes is positively related to the size of the maturity difference between the firm's nominal assets and liabilities.     

THE IMPACT FOR STOCKHOLDERS WHEN REGULATED FIRMS REVISE DIVIDEND POLICY

This study examines the stock market's response when dividend policy changes are made by firms in a heavily regulated industry. Electric utilities are chosen because these firms are regulated in many ways. Regulatory control covers rates of return, pricing, markets and many other areas. This study focuses on dividend changes which follow a period of dividend stability. The results indicate that electric utility firms' stock prices adjust accordingly at the time of the announcement. The market reaction appears to be greater than that of previous studies which considered many industries.     

Did Subjectivity Play a Role in CDO Credit Ratings?

Analyzing 916 collateralized debt obligations (CDOs), we find that a top credit rating agency frequently made positive adjustments beyond its main model that amounted to increasingly larger AAA tranche sizes. These adjustments are difficult to explain by likely determinants, but exhibit a clear pattern: CDOs with smaller model‐implied AAA sizes receive larger adjustments. CDOs with larger adjustments experience more severe subsequent downgrading. Additionally, prior to April 2007, 91.2% of AAA‐rated CDOs only comply with the credit rating agency's own AA default rate standard. Accounting for adjustments and the criterion deviation indicates that on average AAA tranches were structured to BBB support levels.     

Intra-industry transfer effects of credit risk news: Rated versus unrated rivals

We examine the information transfer effect of bond-rating adjustments on industry rivals. Our research is based on the premise that the transfer effect is influenced by the rated status of rivals, i.e., whether the rival’s debt is rated by any credit rating agency. The results reveal that credit rating adjustments induce different/stronger effects. First, the intra-industry transfer effects (on returns and risk) are stronger on rated rivals than on unrated rivals. Second, the credit risk news produces lower co-movements between the returns of the two types of rivals. Third, the differential effect is stronger in the manufacturing industry, in the riskiest industries and in the industries with the lowest competition levels. Interestingly, our results suggest that credit rating news is more relevant for rivals with access to the public debt market (such as re-rated firms) than for rivals that focus on other sources of funding.     

Competition in the credit rating Industry: Benefits for investors and issuers

We empirically investigate the benefits of multiple ratings not only at issuance of debt instruments but also during the subsequent monitoring phase. Using a record of monthly credit rating migration data on all U.S. residential mortgage-backed securities rated by Standard & Poor's, Moody's, and Fitch between 1985 and 2012 (154,600 tranches), our results provide empirical evidence that rating agencies put more effort in rating and outlook revisions when tranches have assigned multiple ratings. Furthermore, we see that in the case of multiple ratings, agencies do a better job in discriminating tranches with respect to default risk. On the downside, we observe a shift in collateral towards senior tranches and incentives for issuers to engage in rating shopping activities, but find no evidence that rating agencies exploit such behavior to attract more rating business. Our results contribute to the literature on information production of credit ratings and extend the perspective to the monitoring period after issuance.     

Moody's and S&P Ratings: Are They Equivalent? Conservative Ratings and Split Rated Bond Yields

We examine the relative impact of Moody's and S&P ratings on bond yields and find that at issuance, yields on split rated bonds with superior Moody's ratings are about 8 basis points lower than yields on split rated bonds with superior S&P ratings. This suggests that investors differentiate between the two ratings and assign more weight to the ratings from Moody’s, the more conservative rating agency. Moody's becomes more conservative after 1998 and the impact of a superior Moody's rating becomes stronger. Furthermore, the differential impact of the two ratings is more pronounced for the more opaque Rule 144A issues.     

ESG in credit ratings and the impact on financial markets

This study examines environment, social, governance (ESG) consideration in rating reports published by credit rating agencies. 3,719 Moody's credit rating reports between 2004 and 2015 are examined and the ESG consideration is analyzed using a latent dirichlet allocation (LDA) approach. We further analyze the stock returns and credit default swap (CDS) spread changes to check whether ESG consideration has an effect on the capital market reactions. We find a small but present consideration of ESG in rating decisions. Within ESG, corporate governance plays the most important role. Moreover, the results reveal that ESG consideration is a significant determinant in the stock return and CDS spread around the rating announcement. We find that all ESG criteria are important for equity and debt investors.     

Banks as lenders and shareholders: Evidence from Japan

This paper examines the effects of the main bank's equity–debt structure, (i.e., equity stakes and debt claims) on firm performance and financial policies in Japan over the period 1977–1987. Results show that firms with main bank equity stakes have lower performance than those without. However, among firms with main bank equity stakes, the equity–debt structure of claims has a positive effect on firm performance. The positive effect of the main bank's equity–debt structure is found to be greater in group-affiliated firms than in independent firms. The main bank maximizes its own interests by charging a higher interest rate when its equity stakes are relatively less than its debt claims and by prompting firms to pay more dividends when its equity stakes are relatively high.     

Rating or no rating? That is the question: an empirical examination of UK companies

The aim of this paper is to examine the main determinants of the rating likelihood of UK companies. We use a binary probit specification to model the main drivers of a firm's propensity to be rated. Using a sample of 245 non-financial UK companies over the period 1995–2006, representing up to 2872 firm years, the study establishes important differences in the financial profiles of rated and non-rated firms. The results of the rating likelihood models indicate that the decision to obtain a rating is driven by a company's financial risk, solvency, default risk, public debt issuance, R&D, and institutional ownership, thus identifying a wider range of determinants and extending the current literature. The study also finds that the rating decision can be modelled by means of a contemporaneous or predictive specification without any loss of efficiency or classification accuracy. This offers support to the argument that the rating process is fundamentally forward-looking.     

The sensitivity of Japanese bank stock returns to economic factors: An examination of asset/liability differences and main bank status

The sensitivity of Japanese bank stock returns to market return innovations (shocks), innovations in Japanese government bond returns, trade-weighted yen exchange rate return innovations, and interest rate spread changes are examined. Japanese bank stock returns are found to be significantly and usually negatively related to long-term interest rate innovations in 34% of all regressions. Market β's are found to be always highly significant, while few of the exchange rate return β's and spread β's are significant. Cross-sectional differences in the market and bond return β's are examined. Japanese main banks are generally found to assume more risk, based on market β's.