1. What Can We Learn About Capital Structure from Bond Credit Spreads? Mark J. Flannery University of Florida Stanislava (Stas) Nikolova George Mason University Özde Öztekin University of Florida Prepared for presentation at the Sixth Annual Bank Research Conference FDIC Center for Financial Research JFSR (New Title)

2. Two lines of recent research initially seem quite distinct from one another: Determinants of corporate bonds’ credit spreads How (if) a firm selects an optimal capital structure.

3. Bond Credit Spreads At least some part is due to potential default losses. –Taxes may also be part –Likewise (il-)liquidity Merton’s (1974) structural model of credit spreads –Assumes current debt level remains unchanged through maturity –Tends to estimate credit spreads that are “too small” Collin-Dufresne and Goldstein (JF 2001) argue that mean-reverting leverage implies more realistic spreads. I.e., larger.

4. Bases for mean reversion 1.Target adjustment model 2.Borrowing constraints limit leverage (concern for credit rating) 3.Pecking order does not imply mean reversion, but may imply predictability. Begin our investigation by regressing leverage on lagged CS, controlling for lagged leverage.

5. Credit spreads correlated with subsequent leverage Using OLS, estimate ΔCS = 1%  ΔLEV = 7% LEV mean- reverts Reverse causation would give negative coefs.

6. So, spreads predict future leverage. How do spreads change contemporaneously? (1) CS i,t is the i th firm’s credit spread at the end of quarter t, LEV i,t is the i th firm’s debt-to-assets ratio, and Z t is a vector of control variables motivated by structural models of credit risk, as in Collin-Dufresne et al. (2001). Re-write equation (1): Difference equation eliminates unobserved, bond-specific features that may affect the credit spread. (2)

7. How might investors form (E t (Lev t+1 ))? Trade-off theory –There is a target –Firms strive to reach it Pecking order theory: Info asymmetry  effect of FINDEF on E t (LEV t+1 ) Other perspectives on leverage movements have no obvious prediction about future leverage.

8. Econometric challenges make direct estimation of capital structure models difficult. Firm-fixed effects seem important. Partial adjustment seems important. How correct dynamic panel bias to adjustment speed? Examine bond credit spreads to infer what investors believe.

9. ΔE t (LEV t+1 ) acc. to Trade-off: LEV* i,t+1 = βX t + ε t+1 X i,t includes size, EBIT, M/B, depreciation, fixed assets, R&D expenditures, industry’s median leverage, bond rating (the usual suspects) Re-arranged:

10. Therefore future leverage is implied by target and current leverage. We need an estimate of LEV* from Alternatively estimate via –Fixed effects, simultaneous estimate of λ –Fixed effects, imposing λ = 1 –OLS, λ = 1

11. ΔE t (LEV t+1 ) according to the Pecking Order theory (6) DIV = cash dividends I = net investments ΔW = the change in working capital C = the firm’s operating cash flow during quarter t

12. Severe information asymmetries  firms prefer to sell debt when FINDEFA > 0 retire debt when FINDEFA < 0 E.g., a non-growing firm has (6) Can predict future leverage by predicting FINDEFA.

13. Data Credit spreads: Lehman-Warga Fixed Income Database (ends in March 1998) –Industrial issuers, fixed-rate bonds –Omit call, put, ABS, maturity < 4 years, short series of observations Firm characteristics: Compustat –“LEV” defined as interest-bearing debt over total (book or “market”) assets. Sample: –626 bonds issued by 246 firms, 1986 – 1998. –More than 10,000 bond-quarter observations.

14. Strategy Estimate: “Pecking-order” Expectations “Trade-off” Expectations

15. Tests of the Trade-off Theory (Table 4)

16. Estimating expected FINDEFA (7) (12) Y i,t includes industry indicator, EBIT, and 1 – 4 lags produces similar results.

17. Tests of the Pecking-order Theory (Table 6)

18. Tests of trade-off and pecking order (Table 8)

19. Conclusions 1.Credit spreads clearly reflect expected changes in future leverage. 2.Pricing supports both the trade-off and pecking order theories of capital structure. 3.Still to do: – explore effects by leverage, maturity, and bond rating. – compare results for market vs. book measures of leverage

20. Triggering Policy Responses with Bond Spreads Goodhart’s law. Discussed in terms of leverage; but it’s a general point to keep in mind.