Corporate Financial Policies in Misvalued Credit Markets

by Jarrad Harford, Marc Martos-Vila & Matthew Rhodes-Kropf
 
 

Overview — The potential for overvaluation to impact firm decision-making is a potent idea with a long history in economic scholarship from foundational works to modern day texts. However, virtually all work on this idea has considered the potential for equity overvaluation to have an impact. The impact of bond market overvaluation on firm policies has thus far received little attention. This limited focus on potential debt market overvaluation is surprising given its size and importance to the economy: the US corporate bond market comprised $7.7 trillion in assets in 2011. The authors begin to fill the gap in scholarship by introducing the idea that mistakes made by the rating agencies should be correlated with bond pricing mistakes. They then examine the correlation in bond rating mistakes with the issuance decisions of firms as well as their cash holding, investment, and acquisition decisions. Findings include evidence that firms take advantage of inaccuracies by issuing more debt and increasing leverage. The result goes beyond a wealth transfer and has real investment implications: approximately 75 percent of the debt issuance funds increased capital expenditures and cash acquisitions. Key concepts include:

  • Two of the most important questions in financial economics are: Why do firms choose to issue debt or equity? What causes firms to invest?
  • This study shows that firms take advantage of inaccuracies by issuing more debt and increasing leverage. The evidence is suggestive of managers' awareness of the mistakes in real time and an active exploitation of them.
  • Misvaluation affects financially constrained firms the most, supporting the theoretical prediction that debt overvaluation loosens financial constraints.

Author Abstract

We theoretically and empirically investigate the repercussions of credit market misvaluation for a firm's borrowing and investment decisions. Using an ex-post measure of the accuracy of credit ratings to capture debt market misvaluation, we find evidence that firms take advantage of inaccuracies by issuing more debt and increasing leverage. The result goes beyond a wealth transfer and has real investment implications: approximately 75% of the debt issuance funds increased capital expenditures and cash acquisitions. In the cross section, misvaluation affects financially constrained firms the most, supporting the theoretical prediction that debt overvaluation loosens financial constraints.

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