A well-documented empirical regularity of U.S. cyclical fluctuations is the fact that the cross-sectional dispersion of economic returns such as labor income, profits, or stock returns increases significantly during economic downturns. These countercyclical changes in the variance of the distribution of returns imply that economic agents make their decisions in an environment of time-varying uncertainty.
The notion of investment irreversibility provides the traditional mechanism through which changes in uncertainty, by altering the “option value of waiting,” affect the macroeconomy; see for example, Bernanke [1983], McDonald and Siegel [1986], Dixit and Pindyck [1994], and Caballero and Pindyck [1996]. As emphasized by Abel [1983], Abel and Eberly [1999], and Veracierto [2002], however, the effect of uncertainty on aggregate investment can be theoretically ambiguous, because it depends importantly on the assumptions regarding the initial accumulation of capital, market structure, and the equilibrium setting. As a result, the literature on irreversible investment lacks a consensus regarding the effect on economic activity from fluctuations in uncertainty.
The presence of credit market frictions reflecting agency problems between borrowers and lenders offers another potential channel through which changes in uncertainty can influence investment dynamics. According to the standard bond-pricing framework (e.g., Merton [1974]), the return function of holders of risky corporate debt is a concave function of the firm’s stochastic return. Thus a mean-preserving spread in the distribution of the underlying shocks that is, an increase in uncertainty will cause lenders to demand a higher risk premium, in order to be compensated for the increase in the downside risk.
This feature of the standard debt contract has two important implications for the relationship between uncertainty and investment. First, to the extent that firms face significant frictions in credit markets, a higher corporate bond risk premium implies an increase in the cost of capital and hence a reduction in investment; in such environment, uncertainty can have a significant effect on investment absent any investment irreversibility or managerial risk aversion. Second, if credit market frictions are an important mechanism through which uncertainty affects investment, then the inclusion of the bond risk premium in an empirical investment equation should significantly attenuate the direct effect of uncertainty on investment. Consequently, the well-known “bad news principle” articulated by Bernanke [1983] could reflect, in part, the option-like structure of the standard debt contract as well as some form of investment irreversibility.
In this paper, we analyze the interaction between uncertainty and investment in the presence of financial market frictions. To motivate our theoretical framework, we first document a strong statistical relationship between time-varying uncertainty and risk premiums on corporate bonds, using both aggregate time-series and firm-level data. Our empirical results, based on a large firm-level panel data set linking prices of the firm’s outstanding unsecured bonds trading in the secondary market to the firm’s equity valuations and its income and balance sheet data, indicate that an increase in uncertainty leads to the widening of yield spreads on corporate bonds, even when controlling for the firm’s leverage, expected return on its assets, and the firm’s credit rating.
Increases in credit spreads conditional on standard investment fundamentals measuring the marginal product of capital are strongly associated with declines in firm-level investment. Moreover, when we include credit spreads in an empirical investment equation augmented with measures of uncertainty, the direct effect of uncertainty on investment is significantly attenuated, a confluence of results that supports the notion that the impact of uncertainty on investment reflects in part the presence of significant frictions in credit markets.
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