In the standard theory of corporate finance, supply conditions in the credit markets have traditionally not been considered as prominent determinants of the firm’s financing decisions and resulting capital structure of the firm. Instead, the theory has been primarily demand-driven: in trade-off theory, firms choose the optimal debt-equity ratio such that the marginal tax benefit of issuing one more unit of debt equals the marginal cost of debt (in the form of increased cost of distress and bankruptcy). In the pecking-order theory, firms raise external funds by choosing the instrument that is the most advantageous given the information asymmetry the firm faces.
More recently, this demand-centric approach to understand capital structure has been called into question. Baker and Wurgler (2002) argue that capital structure is the cumulative outcome of a series of financing decisions in which managers take advantage of temporary market misevaluations, while Welch (2004) argues that managers fail to counteract the mechanistic effects of stock returns on their capital structure and therefore capital structure is almost entirely determined by lagged stock returns. These contributions only focus on the equity/debt choice, implicitly assuming a perfect substitutability between different sources of debt.
However, in cases in which different sources of debt are not perfect substitutes, any variation in credit supply conditions affecting one of them (e.g., the public bond market) will affect the overall leverage. One source of such variation in credit supply conditions is the investor’s credit supply uncertainty. For example, suppose that firm A issues a bond and that this is held by more “stable” investors – i.e., investors who are more likely to stay invested in the market for the long-run. In this case, when firm A’s debt matures and the firm needs to refinance it, current owners of the maturing debt will be likely to be able to roll over the existing debt. Now, suppose that firm B is identical to firm A in all demand-side characteristics but that its bond is held by less stable investors – i.e., investors who are less likely to be in the market for the long run. In this case, there is a higher probability that the current investors’ supply of credit deviates from the amount that firm B needs to refinance its debt when the existing debt matures. That is, there may be supply-induced reasons that generate an imbalance in the credit supply.
To further motivate the concept of credit supply uncertainty (CSU), consider the following scenario. Many of these investors are institutional investors (e.g., bond funds) who face withdrawal risks, and their investment and divestment decisions may be highly correlated with each other if, for example, there is geographic home bias in bond ownership. Whether these bond funds stay in the market for the long haul depends on the withdrawals they face from their end-investors and on the probability that, in meeting these withdrawals, they are subject to a coordination issue with other fellow institutional investors. That is, if sales from some investors operating in a market niche are foreseen by other market participants, they may preempt the sales by selling themselves, generating a run on the assets in that specific niche. This would reduce the stability of the asset prices and generate an imbalance of credit supply. Such an imbalance of credit supply due to turnover is further amplified if the current investors’ purchase and divestment decisions have high correlations, since they are more likely to end up on the same side of the trades. Thus, higher turnover makes refinancing of the bond riskier for firm B relative to firm A.
If there is a variation in the CSU among firms that have access to bond markets, how do firms respond to this factor? In particular, many firms mix bonds and bank loans in their capital structure. On the one hand, if substitution is perfect and cost-free, an increase in the CSU that does not affect supply conditions in bank loan markets should be perfectly cushioned by the firm’s ability to substitute toward bank loan markets. On the other hand, if substitution is less than perfect, either because bank loans are more expensive than bond financing or because banks ration the amount of loans they provide a given borrower, then an increase in the CSU may result in less than perfect substitution towards loan markets, thus reducing leverage of the firm. In addition, if firms substitute toward equity financing in response to the increase in the CSU, then this would further reduce leverage.
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Institutional Investors, Credit Supply Uncertainty, and the Leverage of the Firm
