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Market Conditions and the Structure of Securities

By Harvard Law School Program on Corporate Governance

In a recent working paper Market Conditions and the Structure of Securities my co-authors, Isil Erel, Brandon Julio and Woojin Kim, and I investigate whether market downturns can affect both the ability and manner in which firms raise external financing. Our study was motivated in part by Richard Passov, the longtime treasurer of Pfizer, who argued that the possibility of being shut out of the capital markets during market downturns is the primary reason why Pfizer and other technology companies often place such importance on a high bond rating. The extent to which this concern is justified and macroeconomic factors can affect access to capital is an important issue in finance and has clear policy implications.

To evaluate the extent to which these predictions hold in practice, we assemble a database containing information on alternative ways in which firms can raise capital. Our sample contains detailed information on 21,657 publicly-traded debt issuances and 7,746 seasoned equity offerings in the U.S. between 1971 and 2007. The latter part of our sample (from 1988 to 2007) also includes data on 40,097 completed and mostly syndicated loan tranches. Analysis of this sample provides stylized facts on the nature of public and private debt securities that have been issued recently in the US. The vast majority of external financing is supplied by debt rather than equity. Consequently, understanding the choice between alternative types of debt is likely to be equally important as, or even more important than, the choice between debt and equity. We first provide statistics documenting the average quantity of capital raised though issuance of different kinds of securities during different market conditions. A complicating factor when interpreting these numbers is the enormous increase in the total value of funds raised during our sample period. Nonetheless, there are some noticeable differences in the average proceeds per month raised during weak and strong economic conditions. For example, average proceeds raised per month through SEOs tend to drop during poor market conditions. However, short-term and highly-rated public debt increases noticeably relative to longer-term and lower-rated issues during poor market conditions.

Our multivariate analysis suggests that macroeconomic conditions affect both firms? abilities to raise capital and the manner in which they choose to raise it. We find that the conditional probability of issuing less information sensitive securities, i.e., convertibles rather than equity, increases when credit markets are tight. We do not observe an increase in the demand for bank loans during economic downturns. However, we document that the borrowers of our sample of private loans tend to be of higher quality during bad economic times, consistent with the view that capital available to intermediaries goes down, leading them to tighten lending standards during these periods. In addition to the choice of securities, we also find that market-wide factors affect the structure of debt contracts. In particular, market downturns decrease the expected maturity of public bonds and private loans and increase the likelihood that these bonds and loans are secured. These findings are consistent with the view that market downturns lead firms to structure securities in ways that lessen their information sensitivity. Finally, we consider the quality of the public securities, measured by their ratings. For our sample of public bonds, our results suggest that market downturns do not reduce the issuances of high quality bonds, but are associated with a substantial drop in the likelihood of a junk or unrated bond issue. This pattern suggests that lower quality firms tend to be shut out of the credit markets during poor market conditions.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on May 18, 2009 (boomark / email).