Most of the capital structure literature focuses on demand-side factors, assuming implicitly that supply-side constraints have little effect on capital structure decisions. For example, the trade off theory states that each firm chooses its optimal capital structure by comparing its costs and benefits of issuing new debt, assuming that the supply of capital is infinitely elastic.
Faulkender and Petersen (2006) argue that this is a strong assumption because market frictions, such as asymmetric information and agency costs, that make capital structure relevant could also be associated with a firm’s source of capital. They show that U.S. firms with public bond market access, as measured by having a credit rating, have about six to eight percentage points higher debt ratios than firms without access, after controlling for demand-side factors.
The impact of bond market access on leverage is likely to differ for firms with different credit quality and across countries. Unlike the U.S., which has the world’s largest and deepest bond market in both high and low quality bonds, most countries have small and illiquid markets comprised primarily of high quality bonds. Therefore, low quality firms in most countries could face more severe supply-side constraints relative to high quality firms.
The literature suggests that high quality firms could maintain less than optimal leverage because of their greater concern of rating downgrades whereas low quality firms could increase their leverage after access to public debt market to enhance their financial flexibility (Kisgen, 2006; Gilson and Warner, 1997). Thus, we expect a stronger impact of bond market access on leverage for low quality firms compared to their high quality peers, after controlling for other determinants of leverage.
In this study, we examine this prediction in a sample of Canadian high and low credit quality firms (defined as firms with investment-grade and speculative-grade ratings, respectively) in the 1990-2003 period. We also compare the Canadian findings with the evidence in a U.S. sample of high and low quality firms in the same period.
The Canadian sample provides a rich setting to examine the issue for several reasons. First, Canadian and U.S. bond markets are closely linked, share similar institutional structures, and follow similar credit rating guidelines. These common features provide us with an independent sample to test whether the significant impact of the bond market access on leverage observed in the U.S. also holds in a non-U.S. sample. Second, the Canadian market is small, less liquid, and consists primarily of investment grade bonds. Therefore, low quality (hereafter “LQ”) Canadian firms could be more credit-constrained and are more likely to increase leverage to enhance their financial flexibility than their high quality (hereafter “HQ”) peers. Lastly, the Canadian bond market has increasingly integrated with the U.S. market, and Canadian firms with ratings can access the U.S. market using primarily the Canadian disclosures.
However, while Canadian HQ firms can issue debt in the Canadian or U.S. market, the almost non-existent Canadian high-yield market implies that Canadian LQ firms have little choice but to access the U.S. high yield market for their financing needs similar to their U.S. LQ peers. This common source of financing for both Canadian and U.S. LQ firms provides us with a natural experiment to test whether and to what extent the Canada U.S. bond market integration mitigates the financial constraints faced by the Canadian LQ firms in their home market.
Download
PDF Ebook Bond Market Access, Credit Quality, and Capital Structure: Canadian Evidence
