By Mike Harmon (Gaviota Advisors, LLC) and Claudia Robles-Garcia (Stanford Graduate School of Business)
Corporate leveraged finance cycles have followed a predictable pattern in the forty years that have ensued since the invention of the junk bond in the late 1970s. They expand as investors’ risk appetites grow and recede as default rates rise. The recession of credit cycles has historically facilitated a healthy “creative destruction” in the form of restructuring transactions which have enabled over-leveraged companies to fix their burdened balance sheets. While the current credit cycle is positioned to share some of the characteristics of past cycles, it is also shaping up to differentiate itself in some meaningful ways. First, companies entered the current crisis with significantly more debt, and with that debt bearing a much higher blended risk profile, than in past cycles. Second, the restructuring “fix” has required much more additional financing than previous cycles, due to the economic nature of the crisis. Third, companies have had much more contractual leeway to avoid default, and to solve their liquidity problems with more leverage, than they have in previous cycles. Fourth, many investors have been aligned with borrowers on their desire to maintain elevated leverage levels. And finally, and probably most importantly, the Fed’s actions have facilitated, and even encouraged, the raising of more leverage. As a result of all of these factors, we believe that this restructuring cycle is more likely to see companies emerge with significantly more debt than we have seen in previous cycles. This will exacerbate the highly publicized “zombie” problem (where companies that are technically insolvent have no real catalyst to restructure), which could impact economic growth, and will increase the likelihood of a more protracted restructuring cycle in the years to come.
By Efraim Benmelech (Northwestern University – Kellogg School of Managemen, Nitish Kumar (University of Florida), and Raghuram Rajan (University of Chicago – Booth School of Business)
Is collateral at all valuable to creditors in corporate lending? At one level, it is clear why collateral should be important for lenders: it consists of hard assets that are not subject to asymmetric valuations in markets and that the borrower cannot alter easily. Collateral gives comfort to a lender that, even if the lender does little to monitor the borrower’s activity and the borrower’s cash flows prove inadequate to service the debt, the lender’s claim is protected by underlying value.
Yet even if assets are important to lending, why does debt need to be secured by them? After all, in a bankruptcy filing the firm’s assets will all be there to support the lender’s claim. Why protect the lender further through claims on specific collateral? In a related work (The Decline of Secured Debt), we find that firms tend to issue more secured debt when their credit quality is low or at times when average credit spreads across firms are higher or economic growth is slower. These are times when firms may find access to credit more difficult, creditors may fear greater stockholder-debtholder conflicts, and borrowers may need to collateralize debt issuances in order to regain access to funding. Moreover, with new lenders unwilling to lend without the comfort of collateral, existing lenders might rush to secure their claims so as not to be diluted. Indeed, negative pledge clauses (whereby the borrower commits to a lender that it will not issue secured debt to any other lender, failing which the debt payment will be accelerated) allow creditors to large companies to stay unsecured until they sense a greater likelihood of borrower distress, at which point they will move to secure their claims.
If collateral matters to creditors for the enforcement of debt claims, even in the case of large, mature companies but in a more contingent way, we should see it reflected in the pricing of secured claims vis-à-vis unsecured claims, especially in how that pricing moves with the state of the firm and the economy. Security should be of little value to lenders when a firm is far from distress or the economy is healthy, and it should become much more valuable (and hence secured debt should promise lower interest rates than unsecured debt) as a firm nears distress or the economy deteriorates.
The difficulty in identifying the effects of security on debt pricing derives from the circumstances under which it is offered. Since riskier firms will offer security at riskier times, a comparison of rates offered by secured debt issuances against rates offered by unsecured debt issuances across firms, or by the same firm over time, will tend to be biased toward suggesting higher rates for secured debt issuances.
In this paper, we use multiple data sets to get at the true pricing of secured debt, stripped as best as possible of the selection bias. Our identification strategy compares spreads on secured and unsecured credit of the same firm and at the same point in time.
We conclude from all these ways of obtaining the value of security that the selection bias is important, and correcting for it suggests that security is valuable to creditors – creditors typically require a lower spread when their claim is secured. Most important, however, we show that creditors value security differently for different firms and at different times.
For highly rated firms, creditors pay almost nothing for the added protection afforded by security, whereas for low-rated firms, they pay a lot. Yields on bonds issued by investment grade firms (those with an S&P rating of BBB− or better) are 20 basis points lower when secured, whereas this yield differential (unsecured versus secured) jumps to 112 basis points for a firm having a non-investment grade rating. Similarly, implied yields from bond trades in secondary market suggest that investors are willing to give up almost 161 basis points in spread for the added protection of security for non-investment grade issuers, whereas they are not willing to reduce spread at all for the added protection of security in the case of investment grade issuers.
Equally important, as a firm’s credit quality deteriorates, we see the valuation of secured claims improve relative to unsecured claims, suggesting that security becomes more valuable. We also find that secured spreads decline relative to unsecured spreads as the economy’s health – as reflected in GDP growth or the economywide Baa–Aaa spread – deteriorates.
The upshot is that collateral does not seem to matter for debt enforcement in normal times for a healthy firm, since debt linked to specific assets do not seem to enjoy better prices. Indeed, given the negligible pricing benefit, firms may want to avoid any loss in financial slack and operational flexibility at such times by not issuing secured debt. However, in tougher times, creditors do seem to value security, and firms do issue secured debt, either because creditors demand it or because of the better pricing.