Essays on Corporate Credit

This dissertation consists of three chapters related to issues in corporate credit. The first chapter studies whether credit rating agencies applied consistent rating standards to U.S. corporate bonds over the expansion and recession periods between 2002 and 2011. Based on estimates of issuing firms' credit quality from a structural model, I find that rating standards are in fact procyclical: ratings are stricter during an economic downturn than an expansion. As a result, firms receive overly pessimistic ratings in a recession, relative to during an expansion. I further show that a procyclical rating policy amplifies the variation in corporate credit spreads, accounting for, on average, 11 percent of the increase in spreads during a recession. In the cross section, firms with a higher rollover rate of debt, fewer alternative channels to convey their credit quality to the market, and firms that are more sensitive business to economic cycles are more affected by the procyclical rating policy. The second chapter quantifies the causal effect of borrowing cost on firms' investment decisions. To overcome the empirical challenge due to a possible reverse causality where firms' investment prospects affect their borrowing costs, I apply an instrumental variable methodology where the identification comes from insurance companies' regulatory constraints regarding the credit rating of their bond holdings. Rating-based regulatory constraints are more binding for insurers with a weaker capital position. For this reason, bonds upon downgrades face different degrees of selling pressure depending on the different capital positions of their holders. Such differences are presumably not correlated with issuers' investment prospects. Using data from 2004-2010, I estimate that a one percentage-point increase in bond spread reduces investment during the same year by 12 percent. Moreover, a five percentage-point increase in bond spread halves the probability of new debt issuance. Finally, in the third chapter, when the bankruptcy code protects the rights of lenders, I and my co-author Suresh Sundaresan show that there is no intrinsic reason to issue debt with safe harbor provisions. When the code violates APR or results in significant dead-weight losses, the optimal liability structure includes secured short-term debt, with safe harbor protection. The borrower is able to trade off between "run prone" safe harbored short-term debt and long-term debt depending on the inefficiencies in bankruptcy code, and the availability of eligible collateral to increase the overall value of the firm. The presence of a secured short-term debt will increase the spread of long term debt, and this reduces the long-term debt capacity of firms. Overall, the combined debt capacity increases for the firm. Using the onset of credit crisis in 2007 as an exogenous adverse shock to the collateral value of assets and to the riskiness of collateral, we find that the leverage and short-term debt of financial firms fell much more rapidly than non-financial firms due to the greater exposure of financial firms to "run risk". The provision of short-term credit by the Fed is shown to significantly buffer the reduction in short-term debt and leverage of financial firms, supporting the presence of a supply (of credit) effect in the data. While the Fed's intervention resulted in credit spreads returning to the pre-crisis levels, there was still a net fall in the short-term debt and leverage of financial firms, suggesting a possible demand effect as well. These results are in broad conformity with the theory developed in our results

Loan Terms and Collateral: Evidence from the Bilateral Repo Market

We study secured lending contracts using a novel, loan-by-loan database of bilateral repurchase agreements in which borrower quality is fixed and collateral quality is known. Holding all risk factors constant except collateral quality, we show that loans on riskier collateral have higher spreads, that is, they remain riskier even though lenders require higher margins. We also document that lower-quality loans have longer maturity, driven by borrower rollover concerns. Our results suggest that maturity is not lenders\u27 primary risk management tool. Holding loan quality constant (including collateral), we show that one point of spread substitutes for approximately 9 points of margin

Tricks of the Trade? Pre-Issuance Price Maneuvers by Underwriter-Dealers

We study the trading of dealers around new bond issues underwritten by affiliates using a complete matched record of U.S. bond market transactions, ownership structure, and bond issues from 2005 to 2015. Compared to dealers unaffiliated to the lead underwriter, affiliated dealers pay 30–60 basis points more for the issuer’s preexisting bonds — prior to, during, and after the issuance event. We interpret this phenomenon as price maneuvers aimed at lowering the reference yield for new issue investors. By examining dealer inventories and profits, we find no support for alternative explanations such as hedging, informed trading, or competitive advantage in market-making