Market Quotation and Debt Maturity Structure
Abstract
We analyse debt maturity structure of 16,720 firms in 24 OECD countries between 1990 and 2011.We find that although the size of the banking sector is significantly correlated with debt maturity, its impact depends on the country’s governance index. In strong investor protection countries, firms have more long-term debt when banking sector is bigger and the variation in the size ofthe insurance sector is uncorrelated with debt maturity. In contrast, in weak protection countries with a large insurance sector, firms use more short-term debt. Moreover, we find that, unlike previous studies, firms in strong investor protection countries with developed bond and stock markets tend to use longer debt maturity, but the access to international and non-resident bank debt increases the proportion of long-term debt only in weak protection counties. The results are strong after controlling for signalling, agency cost, asset maturity, and tax effects.
JEL classification: G32
Keywords: Debt maturity; Financial Institutions; Agency Costs; Signalling; Tax
1.Introduction
Previous studies identified four main theories to explain how firms choose between short- and long-term debt in imperfect capital markets: agency costs, signalling, tax, and matching hypotheses. Within the agency costs theory, firms are expected to use more short-term debt to mitigate their underinvestment problem (Myers, 1977) and the asset substitution problem as short-term debt is less sensitive to shifts in the risk of the firm’s underlying assets (Barnea et al., 1980). Similarly, the signalling theory suggests that firms should rely on short-term debt to signal their quality in the presence of transaction costs (Flannery, 1986). In contrast, under the tax hypothesis, firms should prefer to use long-term debt in the presence of a non-monotonic structure of interest rates, when the term structure of interest rates is upward sloping (Brick and Ravid, 1985), Finally, the matching principle argues that debt maturity should be matched with the life maturity of the assets, as when debt has a longer maturity, the firm’s assets should generate enough future cash flow to cover debt obligations. The empirical evidence provided to-date on these factors in single country setting is mixed.[1]More recent evidence that use richer international data to assess the impact of cross-country institutional differences, such as financial and governance systems,is also mixed. For example, while Demirgüç-Kunt and Maksimovic (1999)show that the banking sector is uncorrelated with debt maturity structure of large firms, Fan et al. (2012) find that firms in countries with larger banking sectors use short-term debt, but there is little evidence on the relationship between insurance sectors and corporate financing choices.[2]
We contribute to the literature by assessing debt maturity structure in a multi-country framework. We focus on the impact of the bond markets, and international and non-resident bank debt, in addition to previously documented factors, such as stock market development, insurance and banking sectors, and economic conditions (e.g., Demirgüç-Kunt and Maksimovic, 1999; Sorge and Zhang, 2009;Fan et al., 2012), on debt maturity structures, across 24 OECD countries from 1990 to 2011, resulting in 204,082 firm-year observations. We expect firms in strong investor countries to have longer maturities, as, following La Porta et al. (2000), the corporate governance that accompanies broad financial markets is more effective, the supply of capital is more efficient, and the credit markets is larger than in weak investor protection countries.
We find strong evidence that firms in strong investor countries exhibit significantly higher debt maturities. Our results hold even if we account for all firm and country characteristics. We also show that the US exhibits the highest maturity structure, but, even when the US is excluded, firms in strong governance countriesin the rest of the world (ROW) have statistically higher maturities than firms in weak investor protection systems. We also report that within strong protection countries, the banking sectorhas a positive impact of debt maturity, while within weak protection countries;this association is negative, showing that firms use more short-term debt. These results suggest that banks in strong protection countries are more likely to offer long-term debt consistent with Diamond’s (1984) argument that intermediaries take benefit from economies of scale. While banks in weak protection countries tend to hold more short-term liabilities, and hence offer short-term loans, in line with Fan et al. (2012). Interestingly, while in strong investor protection countries the insurance market is not significant, within the weak investor protection system, firms in countries with bigger insurance sectors tend to use more short-term debt.
Further analysis reveals that in strong protection countries including the US,the bond market development has a positive effect on debt maturity, whereas its effect is insignificant in weak protection countries, although international debt market and non-resident bank loans are positively associated with long-term debt. We find strong evidence to support the impact of developed stock markets only in countries with strong investor protections, suggesting that active stock markets in those countries increase the ability of firms to obtain long-term credit. We also find that firms in weak protection countries tend to use shorter debt maturity when the inflation rate and domestic savings are higher and GDP growth is lower. In contrast, firms in strong protection countries use shorter debt maturity when the inflation rate is lower and GDP growth rate is higher, but the impact of domestic saving on debt maturity is weak.
Considering firm-specific variables, we find strong evidence that debt maturity is longer when firms have higher leverage. Consistent with the agency theory, the market-to-book ratio has a considerable negative effect on debt maturity structure across countries with different governance index. Myers (1977) argues that firms with greater growth opportunities use shorter maturity of debt in order to mitigate the underinvestment problem. We also show that bigger firms with higher profitability tend to use longer debt maturity. Our findings provide strong support for the signalling hypothesis for US firms, in contrast to firms in strong protection countries where the negative effects of abnormal earnings are not significant, and to weak protection counties where the impact of abnormal earnings on debt maturity is positive. The results of the US are in line with those of Barclay and Smith (1995) and Stohs and Mauer (1996), but inconsistent with Ozkan (2000) and Antoniou (2006). We do support the matching principle, which emphasises on matching the debt maturity and asset maturity. In addition, consistent with the tax hypothesis, the term structure of interest rate has a positive and significant effect in strong investor protection countries including the US, suggesting that companies use longer maturity of debtwhen the term structure of interest rate is upward sloping. But we find no evidence to support the impact of the term structure on interest rate within weak protection countries.
The rest of the paper is organised as follows. Section 2 provides the review of the literature and the hypotheses tested. Section 3 discusses the data and the methodology used. Section 4 presents the empirical results and the conclusions are in Section 5.
2. Literature Review
2.1 Institutional Characteristics
There is a growing literature that considers the impact of institutional differences on corporate financing choices. The specific characteristics of countries are likely to highlight a large number of interesting issues relating to the way companies make debt maturity decision. Miller (1977) shows that investors’ preferences for holding debt versus equity affect ta firm’s debt ratio. Consistently, Fan et al. (2012) argue that firms in countries with developed banking system tend to use more short-term debt as banks hold more short-term liabilities. While insurance companies prefer to have long-term assets and thus firms in countries with a larger insurance sector are more likely to use long-term debt. Overall, they consider the preferences of capital suppliers on the structure of debt maturity. Their results support the negative impact of the banking sector on debt maturity, but their results are not consistent with Demirgüç-Kunt and Maksimovic (1999) who find insignificant effects of banking sector on debt maturity.
To proxy for the preferences of the suppliers of the capital, we use banks’ deposits over gross domestic product (GDP) to measure the available funds for the banking sector. We expect that firms in countries with a bigger banking sector tend to use short-term debt. However, banks’ risk will influence the lending and maturity choices of banks. Banks’ capital, measured by banks’ capital over GDP, moderates the risk banks run, and hence reducing banks’ need to seek more liquid short-term debt. Therefore, firms in countries with more bank capital are more likely to use long-term debt. In addition, we use banks’ credit to banks’ deposits to measure their risk. High-credit banks have a greater ability to pay their debt when its due, thereby reducing the risk of banks run. We expect that firms in countries with low-risk banks, measure by banks’ capital and their credit, are more likely to use long-term debt. To proxy for the insurance sector, we use total insurance premium (life and non-life) over GDP. We expect that firms in countries with a bigger insurance sector tend to use long-term debt. To measure the amount of funds available for all financial intermediaries, we use gross domestic saving over GDP, expecting that firms in countries with greater supplier of capital use more long-term debt.
Grossman (1976) argues that prices of listed companies transfer information that can be useful for creditors, and hence lending to quoted firms is less risky due to their transparency in the stock market. Therefore, it is expected that firms in countries with developed stock markets are more able to obtain long-term credit, using more long-term debt.Demirgüç-Kunt and Maksimovic (1996, 1999) show that leverage and debt maturity increase with the size of stock markets. In addition, higher bond market development provides a better protection for borrowers and hence we expect that firms in countries with better and diversified bond markets, measured by bond market capitalisations over GDP, international debt issued over GDP, and loan from non-resident banks over GDP, use more long-term debt.
Finally, we control for the economic condition using the inflation and GDP growth rates. Inflation makes it costly for firms and investors to contract (Demirgüç-Kunt and Maksimovic 1999)and we expect that firms use more short-term debt when the inflation rate is high while they use long-term debt when the GDP growth is high. The inflation rate is measured by annual rate of change on consumer price index.
2.2 Firms’ Characteristics
A large number of empirical studies have investigated the impact of firms’ characteristics on debt maturity based on four main theories; signalling, tax, agency costs, and matching principles.
Myers (1977) refers to the conflict between debt-holders and shareholders, which result in the underinvestment problem. This problem arises when debt-holders desire to invest in safe projects that may not create any benefits for shareholders. Accordingly, shareholders may reject positive NPV projects. Conversely, shareholders get the benefits of investing in a negative NPV project at the expense of debt-holders. In this situation, debt-holders will lose if the project is unsuccessful while equity-holders would not be affected. He suggests that the underinvestment problem can be mitigated by using short-term debt because it matures before the growth opportunities will be exercised. Following empirical studies (Titman and Wessles, 1988; Rajan and Zingales, 1995; Guedes and Opler, 1996), we use market-to-book ratios to measure growth opportunities to control for agency conflicts.
Brick and Ravid (1985) provide a model for debt maturity structure based on tax effects. They show that when the term structure of interest rate is upward sloping, the value of firm is increasing function of long-term debt. The reason is that tax shields of interest payments would be accelerated by using long-term debt. Their model is characterised conditions under which firms consider first their capital structure and then their structure of debt maturity. By contrast, when leverage and debt maturity are considered simultaneously, Lewis (1990) shows that the tax does not have any effect on the structure of debt maturity. He assumes that there is no differencein tax expenses between short-term and long-term debt.
The literature investigates the effect of tax on debt maturity, but this literature provides mixed evidence for tax effects. Using small and medium sized companies, Garcia-Teruel and Martinez-Solano (2007) find a positive relationship between the term structure of interest rate and the maturity structure of debt. Their results are consistent with the model provided by Brick and Ravid (1985). However, Scherr and Hulburt (2001) provide limited evidence for the impact of tax. Barclay and Smith (1995) and Guedes and Oplimer (1996) studying US large companies, and Ozkan (2000) studying UK large companies, do not support the tax effect. Following Brick and Ravid (1985), we use term structure of interest rate to test the tax hypothesis and its subsequent effects on debt maturity structure. We expect that companies use long-term debt when the term structure of interest rate is upward sloping. Falnnery (1986) develops a model to show that a firm’s debt maturity structure can signal information about its quality. In that model, under asymmetric information, high quality firms use short-term debt to signal the markets that they can afford to repay the short-term principal when it is due. He argues that, under asymmetric information, both long-term debt and short-term debt are mispriced in the market. However, long-term debt is more sensitive to asymmetric information. Therefore, when the capital market cannot distinguish between low quality and high quality firms, high quality ones suppose that long-term debt is relatively overpriced and prefer to issue short-term debt while low quality firms decide to issue overpriced debt (long-term debt). Hence, in the presence of transaction costs, low quality firms cannot imitate high quality ones. High quality firms use short-term debt to signal markets that they can afford to repay the short-term covenant when it is due, while low quality firms cannot afford to roll over short-term debt, and hence prefer to issue long-term debt (Falnnery, 1986).Todate, empirical studies use abnormal earnings as proxies for firms’ quality (e.g., Barclay and Smith, 1995; Stohs and Mauer, 1996; and Ozkan, 2002).[3] Studying large companies, Stohs and Mauer (1996) report a negative relationship between firms’ quality and the maturity structure of debt. Their results are in line with those of Barclay and Smith (1995), who find a negative relationship between long-term debt and abnormal earnings as a proxy for firms’ quality, supporting the signalling hypothesis. But their results are inconsistent with the findings of Ozkan (2000) and Antoniou et al. (2006), who do not provide any evidence to support the signalling hypothesis.
Morris (1976) theoretically shows that firms can choose the debt maturity along with their assets life to mitigate the risk when their cash flows are not sufficient to cover their commitments. Therefore, it is expected that cash flows generated by assets will be sufficient to pay their commitments. Debt with maturity longer than the maturity of assets is risky because the assets may not be enough to repay the debt covenants. Consequently, maturity matching could mitigate the expected costs of financial risk. Based on this notion, firms with more long-term assets use longer maturity debt, and thus a positive association would be expected.
3. Data and Methodology
We first collect all firms registered in OECD countries from DataStream. We exclude Korea, Czech Republic, Solvak Republic, Iceland, and Greece for lack or unreliable data, leaving us 24 OECD countries. We exclude financial firms and those non-financial firms with negative book equity. Our sample includes 16,720 firms from 1990 to 2012, resulting in 204,082 firm-year observations. Data for firm-specific variables are collected form DataStream. Data on country-specific variables are collected from several sources which are specified in Table 1.
[Insert Table 1 here]
To test our hypotheses, we use the fixed-effects model, Equation (1):
Equation (1)