By Bo Becker (Stockholm School of Economics) and Victoria Ivashina (Harvard Business School)
Corporate bond defaults have been on a long and powerful upward trajectory in the past few decades. The default rate of U.S. corporate bonds rose from 0.12 percent to 0.46 percent between the first and second halves of the period from 1970 to 2016—an increase of almost four times. The rating agency Moody’s reports that, of the ten years with the highest default rates since 1960, six occurred in the new millennium and none before 1990. In a recent working paper, we investigate the role of disruption in explaining this trend.
By disruption, we refer to the process whereby new firms replace old firms using innovations in their business models, operations, or new technology. This process causes incumbent firms to lose market share, suffer reduced profitability, and, as we demonstrate, default on debt obligations. Just to name a few of the many recent examples: single-location bookstores were disrupted by chain stores, which were in turn disrupted by online bookstores, and off-line travel agents were disrupted by online services.
In our study, we compare industries with high rates of arrival of new firms, measured as either venture capital investments in the sector over the last five years or as the fraction of public firms in the industry with an IPO date in the past five years. The two variables capture different stages of disruptors’ ascent. While one can easily think of several broad forces that have increased innovation and disruption over the past few decades, different industries have been affected at different speed and different depth. We exploit this variation to draw the connection between disruption and defaults.
Our measures of disruption positively predict future defaults on corporate bonds, controlling for a host of other factors (including time, industry, bond characteristics such as seniority and callability, and issuer characteristics such as credit rating). These bonds are largely issued by mature firms (startups rarely access the bond market). Not only are future defaults higher in industries with high rates of disruption, but the bond market prices this in: newly issued bonds in high-disruption industries have higher yields. These findings are surprising, as a reasonable expectation might be that firms in the same industry would generally suffer similar fates. We would then expect to see high rates of new firm creation coupled with low defaults on the debt (of incumbents). Instead, we find the opposite.
An active IPO market and elevated venture capital investment may help the inception and advancement of potential disruptors, but underlying causes may be found in technological shifts (information technology, mobile, and ,in an earlier era, perhaps electricity), deregulation (think airlines), and globalization (in our data, industries directly exposed to off-shoring are no more likely to see defaults; however, global markets may have an important role in scaling up the opportunities available for disruptive businesses).
The importance of disruption probably extends beyond creditors to other stakeholders of incumbent firms. The corporate bond market is useful for studying disruption because bonds are liquid securities with detailed, high-quality data. Furthermore, losses on corporate bonds are important because bonds are widely held. This is in contrast with the gains from disruption, which tend to be concentrated with entrepreneurs and venture capital investors.