The collapse of financial institutions such as Bear Stearns and Lehman Brothers during the recent financial crisis has starkly highlighted the risk of financing long-term assets with short-term debt, which exposes the firm to the risk that it may not be able to roll over its maturing debt if its fundamentals or market conditions deteriorate. The collapse of these institutions was all the more spectacular because it wasn’t anticipated by any of the three major credit rating agencies. The problem is not just confined to banks and investment banks. There is a long history of high-profile bankruptcies involving non-banking firms, where the inability to roll over short-term debt compounded the effect of operating losses, and led to sudden collapses that the credit rating agencies failed to anticipate; e.g., WorldCom (2002), Enron (2001), First Executive Corporation (1991), and Penn Central (1970).
The above evidence raises two important and related questions which are the focus of our paper: Does the debt maturity structure of a firm affect its overall credit risk? If so, do credit ratings adequately capture this effect? An emerging theoretical literature argues that the rollover risk emanating from a firm’s reliance on short-term debt increases the firm’s overall credit risk, because rollover risk makes the firm susceptible to a run by its creditors (Morris and Shin (2009), He and Xiong (2010b)) and diminishes its debt capacity (Acharya et al. (2010)). If these theoretical predictions are correct, then firms with greater exposure to rollover risk should, all else equal, face a higher cost of debt and should be more susceptible to a deterioration in their credit quality. Ours is the first paper that empirically investigates whether these predictions are true.
Our sample spans the time period 1980–2008, and includes all firms that have a long-term credit rating from Standard and Poor’s (S&P) and for which financial information is available in the Compustat database. We measure a firm’s exposure to rollover risk using the variable Rollover, which we define as the proportion of the firm’s total debt that is maturing within the year. We begin our analysis by examining whether the yield spreads on a firm’s bonds are affected by the maturity structure of its debt, after controlling for all other factors that the existing literature has shown to affect bond yields, including the firm’s credit rating. To do this, we follow Campbell and Taksler (2003) and model a bond’s yield spread as a function of the issuing firms idiosyncratic volatility, average return, credit rating, various financial ratios including Rollover, and macroeconomic variables such as market volatility and average market return. We find that bonds issued by firms with higher values of Rollover have higher yield spreads, even after controlling for the firm’s credit rating: a one-standard-deviation increase in Rollover is associated with a 5 basis point increase in the bond’s yield spread. This finding highlights that rollover risk increases a firm’s overall credit risk, over and above what is captured by its credit rating.
A sharper test of the rollover risk hypothesis is whether firms with a higher proportion of debt maturing in the short term are, all else equal, more likely to experience a deterioration in their credit quality. One way to identify deterioration in credit quality is using the ‘D’ rating which is assigned to firms that have defaulted on their debt obligations. However, a more common form of deterioration in credit quality is when firms experience rating downgrades, but do not actually default on their obligations. Thus, we measure deterioration in credit quality using the number of notches by which the firm’s credit rating has been downgraded during the year, and by using a dummy variable that identifies firms that have experienced multi-notch downgrades, i.e., downgrades of more than one notch during the year.
