Academic journal article Quarterly Journal of Finance and Accounting

Expected Future Interest Rates and the Timing of Private Placements

Academic journal article Quarterly Journal of Finance and Accounting

Expected Future Interest Rates and the Timing of Private Placements

Article excerpt

Introduction

The research on debt market timing started with Taggart (1977) and Marsh (1982). These two studies show that there is a significant relationship between interest rates and the amount borrowed in debt markets. When interest rates are high (low) at the time of the borrowing, firms tend to borrow less (more). In other words, the findings in Taggart (1977) and Marsh (1982) imply that in order to reduce their cost of capital, firms use historical interest rates as a tool to time the debt markets.

More recently, Barclay and Smith (1995), Guedes and Opler (1996) and Stohs and Mauer (1996) examine the relation between the maturity choice and term premium (the difference between the yields of long- and short-term government debt). While Guedes and Opler (1996) use data on new debt issues, Barclay and Smith (1995) and Stohs and Mauer (1996) use balance sheet data on debt. All three studies find that debt maturities tend to be shorter when the term premium is higher. In other words, in order to reduce their cost of capital, firms tend to choose shorter (longer) maturities when the term premium gets larger (smaller). Later, Baker et al. (2003) confirm these findings and show that managers try to time the debt market using publicly available data on market conditions (e.g., inflation, the real short-term rate and the term spread) as a guide to their maturity decisions. They show that corporations time the bond market by choosing longer maturities when future excess bond returns are predictably low.

Graham and Harvey (2001) and Bancel and Mittoo's (2004) surveys of American and European financial managers, respectively, reveal that a large fraction of chief financial officers prefer shorter (longer) maturities when the term premium gets larger (smaller). So, these two surveys confirm the findings of Barclay and Smith (1995), Guedes and Opler (1996), Stohs and Mauer (1996) and Baker et al. (2003) regarding the relation between the maturity choice and term premium.

Interestingly, Butler et al. (2004) show that, contrary to existing evidence, corporate managers cannot successfully time the maturity of their debt issues to reduce their cost of capital. They argue that the negative correlation between future excess long-term bond returns and the ratio of long-term debt issues to total debt issues is driven by aggregate pseudo market timing. In other words, firms are just reacting to (as opposed to forecasting) the increase in the relative cost of long-term debt (due to the monetary and fiscal policy of the United States government during the early 1980s) by issuing more short-term debt. They show that after accounting for this structural shift, there is no evidence that corporate managers are able to predict future variations in bond returns or to successfully lower their cost of capital by timing the maturity of their debt issues.

According to Barry et al. (2008), there are two types of (potential) debt market timing: "backward-looking market timing," where managers use the historical rates as a timing tool; and "forward-looking market timing," where managers use the term spread as a timing tool. The authors show that managers cannot successfully time future interest rates. More specifically, they show that managers do not issue more debt or longer maturity debt before rate increases or less debt or shorter maturity debt before rate declines. On the other hand, the authors find evidence of backward-looking market timing. They find that the level of interest rates relative to historical levels strongly affects debt issuance and debt maturity choice. When the rates are low compared to the historical levels, firms tend to borrow more at longer maturities.

Barry et al. (2008) has one limitation though: They do univariate analyses and do not control for firm characteristics like size, profitability, tangibility, market-to-book ratio, and pre-issue leverage which are shown to be the determinants of capital structure in previous studies. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.