The maturity rat race

It is a common phenomenon nowadays for a lot of firms and financial institutions to invest long-term but at the same time finance themselves short-term. So, why do firms expose themselves to significant risk? This paradox might be the result of an inefficient dynamic that we call a “maturity rat race” ( Markus Brunnermeier, Martin Oehmke, April 2013, The Journal of Finance 68(2)).

First of all, let's assume that we have a borrower who borrows from multiple creditors to finance long-term investments with different expected maturities. So when the interim information coming out at the rollover dates is negative and increases the probability of default rather than to the possible recovery of funds when default occurs, the borrower has the incentive and will probably try to approach one of his creditors and suggest him a change from long-term financing to short-term financing contract. Those shorter maturity claims diminish value of longer maturity creditor’s claims. As a result, the remaining creditors will chase an even shorter maturity for their contacts. This continuous conflict between long-term and short-term creditors leads eventually to a rat race where all the creditors demand short-debt .

This maturity rat race can create serious implications for the future of the firm, since excessive short-term funding leads to extreme rollover risk and causes inefficient liquidation of the long-term investment projects after the negative interim information. At the same time, the rat race leads to underinvestment, with some positive NPV projects not getting started in the first place, and value destruction is observed. This is in contrast with some of the most influential theories on maturity mismatching. An example is the theory of Diamond and Dybvig  (1983), which argues that maturity mismatching facilitates long-term investment projects while serving investors’ liquidity needs. However, it does seem to be consistent with both general theorems and empirical research on the importance of maturity matching in determining an optimal debt maturity structure, stemming from the initial research of Morris (1976). He argues that mismatching maturities creates unnecessary risks for a firm and that it should therefore be avoided. The same tendency comes forward in the "maturity rat race".

Last but not least, during economic crises, when the environments are increasingly volatile and there is no stability, the incentive to shorten the maturity structure is particularly strong, which facilitates the maturity rat race even more . This is because the probability of default is higher and investors try to protect their claims. The authors in the end suggest that future financial regulation should limit maturity mismatches in the financial system especially during future crises for all the above mentioned reasons.

The effect of the global financial crisis on debt financing and debt maturity

On September 15, 2008 the whole world was watching in complete shock the collapse of Lehman Brothers, one of the most respected investment banks worldwide. The crisis spread immediately throughout the whole financial system and is compared by many economists with the Great Depression of the 1930s.

As a result the total amount of debt raised was reduced after crisis. Developed countries debt issuance was reduced by 40 % between 2007 and 2009.  Following the same downward trend, developing countries debt issuance experienced a decline of 15% during 2007-09. (Juan J. Cortina, Tatiana Didier, Sergio L. Schmukler, January 2018, “Corporate Borrowing and Debt Maturity:Market Access and Crisis Effects”)

At the same time:

• The corporate debt turned to bond issuances. During 2007 - 2009  the issuance of corporate bonds expanded by 52% and 96% in developed and developing countries, respectively and at the same time total borrowing in syndicated loan markets vanished by around 62% and 57% in developed and developing countries, respectively.
• Second, in developing economies firms moved towards the less affected domestic markets, increasing domestic bonds and syndicated loan markets. During 2007 - 2009, abroad syndicated loans to developing countries declined by 75 %, whereas the issuance of domestic syndicated loans increased by 104 % over the same period. For corporate bonds, the issuance in foreign markets declined by 14 % , whereas domestic issuances increased by 169 % over the same period. On the contrary, firms from developed countries tried to “move away” from the impacted syndicated loan market. This was translated into a decline in the issuance of both domestic and international syndicated loans and an increase in the issuance of both domestic and international bonds.

Debt maturity is expected to decline during a crisis because firms and finance providers adjust to higher uncertainty, risks and lower returns. Also because banks want to increase their protection and minimize their exposure, they  tighten their lending standards.

However, the results for developed countries show that even though the maturity of issuances of bonds and syndicated loans shortened in both domestic and international markets during the crisis relative to the pre-crisis period, the overall debt maturity did not significantly change. This is explained by the fact that the share of debt financing raised with bonds (which have significantly longer maturity than syndicated loans) increased. As for developing countries, the average maturity of the total new debt increased in the aftermath of the crisis. Whereas the maturity of bonds declined (by about 2 years), the maturity of syndicated loans increased (by about 3 years). The maturity of bonds declined in both domestic and international markets. For syndicated loans, however, the increase in maturity at issuance is explained by the upward tendency for issue in the longer-term domestic markets. (Juan J. Cortina, Tatiana Didier, Sergio L. Schmukler, January 2018, “Corporate Borrowing and Debt Maturity:Market Access and Crisis Effects”)

Last but not least, the markets on which each firm has access is an important factor to consider. During the crisis most of the large firms moved away from the most affected markets with shorter maturity, towards less affected ones switching their financing composition and their debt maturity remained almost stable. But firms that could not choose between markets(usually the sme’s) , and thus continued issuing in the same markets, experienced declining debt financing and maturities. This fact is really crucial since it contradicts one of the most influential theorems in economics and more specifically that “In a world with perfectly integrated and frictionless markets, the specific market in which firms obtain financing would be irrelevant”(Modigliani and Miller, 1958).

To sum up we can easily realize, that the global economic crisis had different effects on each country and each type of firm and and that different debt markets attracts different types of firms and investors, delivering different volumes and terms of financing such as debt maturity. (La Porta et al.; 1997; Karolyi and Stulz, 2003; Pirinsky and Wang, 2006; Japelli and Pagano, 2008; Bekaert et al., 2011).

Tax shield and other advantages of debt financing

Financing your firm by means of debt financing can provide you with a lot of advantages. For example, you won’t have to give up business ownership. Your only obligation is to make payments on time for the life of the loan. In contrast, if you finance your firm using equity, you might have to worry about interference from other parties regarding the future of your firm. Another very useful advantage is the fact that debt can be fuel for growth, especially low-interest long-term loans. These loans can provide your firm with working capital needed to keep the business running smoothly and profitably. Furthermore, debt financing can be very helpful for small business or start-ups, since small business owners rely heavily on expensive debt like cash advances or credit to get their business started. The problem here is that these expensive debts require a lot of cash flow and this can hinder day-to-day operations. Debt financing can provide a solution for these small businesses, since the usage of debt financing can ensure the payoff of these high-cost debts. Because of this, monthly payments can be drastically reduced, resulting in lower cost of capital and boosts of business cash flow. It is therefore often more interesting for start-ups to use debt financing instead of equity financing.

It is clear that debt financing can have a lot of advantages, but one of the most important ones is definitely the tax shield that debt financing creates. A tax shield can be described as an allowable deduction from taxable income that leads to a reduction of taxes owned. The interest on debt is considered an expense, just as any other expense, and taxes are paid after the deduction of this expense. This way, debt creates a certain tax shield. Tax shields provide a way to save cash flows and increase the value of a firm. As a consequence, these tax shields have a big influence on investment strategies, since it is cheaper for firms and investors to finance with debt instead of financing with equity.

As can be observed, a levered firm can pay its investors more cash flows in comparison with an unlevered firm. The difference is the interest tax shield. Note that the interest tax shield can only be positive if the EBIT is greater than the interest payment.

Furthermore, from a more general perspective, tax shields can vary from country to country and are based on what deductions are eligible and ineligible. The most common expenses that can be deductible are interest, mortgage, amortization and depreciation. Governments often use tax shields in order to encourage certain behaviour or investment in different industries. For example, the deduction of mortgage interest is considered a tax shield meant to increase homeownership in the US. This can definitely be a useful benefit for people who are interested in buying a new home while lessening their tax liability. This way, not only firms but also individuals can benefit from a tax shield.

The Role of Debt in Motivating Organizational Efficiency

One of the factors, that influences capital structure of companies, is conflict of interest between shareholders and managers. This theory, which belongs among the main capital structure theories, is also related to the theories that are talking about the role of agency conflicts between these parties. The reason of this conflict is free cash flow that can be either redistributed to the shareholders by dividends or utilized as an investment. On the one hand, shareholders generally want high returns on their equity, so they are expecting that free cash flow will be redistributed to them through dividends. On the other hand, managers want maximize their power and wealth in a company by investing into projects that is not in the best interst of shareholders. According to Jensen (1986), company can reduce agency costs of free cash flow through a debt issue and he called this theory „control hypothesis “.

Literature related to debt financing is often focused on agency costs of debt but the benefits of this type of financing in relation to company efficiency are rarely mentioned. As has been already said, managers want to invest free cash flow to empower their position although some of the investment projects are not very profitable. If free cash flow of a firm is high, managers can either increase dividends or repurchase stocks thereby they will avoid of investing into inefficient projects. The problem of this solution is that control over the future cash flows of a company remains henceforth in the hand of managers. The next option is an issue of bonds in the exchange for stocks. By issuing debt, managers are bonding their promises to pay out future cash flows. Shareholders who obtained the bonds in the replacement of their shares, can enforce their rights for an interest which were promised to them before an exchange. If managers will not pay out this interest, the holders of these bonds have got a right to take a firm into a bankruptcy. In other words, „Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows” (Jensen; 1986). Thus, by reducing of free cash flow that is available for spending of managers, the agency costs of free cash flow are decreased.         

According to Jensen, control effect of debt is a potential determinant of capital structure.

One can notice that debt issue could be an executive tool for increasing company efficiency, however “control hypothesis “ doesn’t claim that it always works in a good manner. This hypothesis doesn’t play a big role in companies which are growing very fast, because they often haven’t got any free cash flow. In the contras with these firms, corporations which haven’t got a big growing potential, but they’ve got a big amount of free cash flow, should be aware of the role of debt in motivating of organizational efficiency. Moreover, an exchange of stocks for debt is also lucrative from the view of tax management of companies, because interest payments are deductible for firms and that part of the repurchase proceeds equal to the seller's tax basis in the stock is not taxed at all.

The choice of debt maturity by credit ratings. (Diamond, 1991)

Diamond (1991) explained the choice of debt maturity related to the credit rating. His model splits the borrowers in two ‘projects’, Project G and Project B. The model evaluates two periods. Both projects have a capital of 1$ in period 0 and a cashflow (X) in period two. There is no cashflow in period one. Long term loans will have a maturity of two periods. Short term loans will have a maturity of one period. The lender will receive a return (R) each period. The maturity of the loan depends if the lender will receive the expected return each period. If the loan will mature two periods the lenders receive 2 x R, which is R².  If the return is lower than expected, the loan will be liquidated. Lenders has the rights to liquidate the short term after period one. This right is not permitted in long term loans. Long term loans has a fixed maturity for period two. Liquidity risk is the risk that a solvent but illiquid borrower is unable to obtain refinancing. The definition of liquidity need to be broadly interpreted. In all cases where the borrower lose control of the loan after period one, the loan is liquidated. In this model both project could be liquidated after period one. The projects are short term loans. In period one the projects can be liquidated for the liquidation value (L). If the liquidation value is higher than the expected return, the lenders will not liquidate the project. This model has no liquidation value after period two. In this model only the borrowers knows the cashflows and expected information. Borrowers and lenders are risk neutral.

Project G receive cashflows (X) higher than the return of the lenders (R). For two periods this means that the cashflows are higher than de total return (R²). ( X> R²) This project results in a positive net present value in terms of cashflows.

Project B receive a probability (π) of the cashflow (X). The probability of no cashflows is 1 - π. For two periods the probability of cashflow (π X) is lower dan the returns of the lender (R²). (πX <R² ) This project results in a negative net present value of the cashflows.

This model explained the debt maturity related to the credit rating. If a borrower has low credit rating the return (R) will be higher. If the R is high the chance for project B is higher and this results in a chance for a negative net present value of the cashflows. The probability of the credit rating for project G is ƒ. The probability of the credit rating for project B is 1 -  ƒ. With this information, the probability of repayment of a loan after period two is: π + ƒ ( 1 - π). This is the probability of cashflows plus the credit rating for project G multiplied by one minus the probability of the cashfows.

After period one there is new information about the borrowers. The credit rating could upgrade or downgrade. Project G can get a upgrade or a downgrade. є is the downgrade and 1 – є is the upgrade for project G. Poject B can only be downgraded because of the negative net present value. The probability of this downgrade depends on the credit rating. Ƒdown is the creditrating for a downgrade. The project will stay project B. ƒ is the credit rating for project G. This is explained by this formula:  (ƒdown ( 1 - ƒ ))/(ƒ ( 1 - ƒdown ))

Because the lenders will have the possibility to liquidate the projects after period one. The choice for the lenders to liquidate or not depends on the value of the loan. The value is equal to the face value (r₁) in period 0. If there is a upgrading in period 1 the face value is equal tot he face value of period 0 multiplied by the returns. (r₁R). The chance for a upgrade is P^u = (1 – є )  ƒ.

The figure illustrate the project conditions.

The research of Diamond (1991) concludes that short debt has a shorter maturity than new investments. New short debt depends on the future credit rating. If the borrowers has a high credit rating they will use more short debt, because of the lower risk. Long term debt matured after new investments. The borrowers do not depend of the new credit rating. If borrowers has a lower credit ratings, they prefer long term loans, because of the risk of downgrading.

Pecking Order Theory: Companies prioritize their sources of financing

Modigliani and Miller (1958, 1963) are regarded as the fathers of the modern theory corporate’s financial structure by putting a valuable framework on the possibilities of arbitration on the financial market. In order to pursue this concept, almost 20 years later, the Pecking Order Theory, firstly occurred by Donaldson, was popularized by Myers & Majluf in 1984 and still remains until today one of the most influential theory of corporate finance.

The Pecking Order Theory suggests that firms follow a specific order to choose their capital sources when funding is needed. As a result, they will prefer internal financing through retained earnings. If internal funds are unavailable or not enough, the company will choose external sources of finance and more specifically debt over equity. Equity is seen as the last resort.

(Internal Financing > Debt > Equity)

Internal funding is mainly used because there are no issuance costs (which makes it the cheapest option) and it requires no private information to share. Nevertheless, companies do not always have the required financial resources that is why they use external sources. The most preferable way of external financing is the issuing of new debt which will increase the proportion of debt in the capital structure and will lead to a tax shield. As a consequence, the WACC will be reduced. But increasing the leverage on the capital structure can become extremely risky after a certain point and this is when the company has to turn to equity financing and issue new equity shares on the market.  

For external sources, the Pecking Order Theory deeply focuses on the asymmetry of information. Managers have normally more information about the company’s performances, value and risks than investors and creditors. Depending on the field in which the company evolves, the asymmetry of information can be higher for instance for high technical and complex product. Therefore, creditors and investors will demand higher returns to finance companies because they have a lack of information.

The choice of finance also sends some signals to the markets. Indeed, if a company finances itself internally, it means it is strong and profitable with durable financial resources and may have lower debt-equity ratios. 

Otherwise, if the firm chooses debt financing, that shows the company’s faith to meet the demands of creditors by paying the fixed fees.

Finally, if equity financing is chosen, the majority of investors will probably hypothesize that the firm is currently overvalued which will hurt not only the reputation of the firm but also its economic sustainability.

The Modigliani-Miller Theorem: still omnipresent after 60 years

If one would ask a random finance student to cite one basic financial theorem, chances are quite high that he or she mentions the likes of Franco Modigliani and Merton Miller, authors of the famous Modigliani-Miller Theorem. To be fair, this cannot be too surprising since the theorem, first published in 1958, provided the foundation for more than half a decade of additional research in the area of corporate finance. Although it relies on quite stringent assumptions, the M&M theorem provides a valuable framework that is used to explain the decisions companies make with regard to their finance mix. To understand how it works, one should look a bit more closely.

Simply put, Modigliani and Miller claim that the value of a company doesn’t depend on the way it is financed. Whether a company relies only on equity financing or it uses a mix of debt and equity, its value stays the same. This is why the M&M theorem is also known as the capital structure irrelevance principle. Important to notice however, is the fact that this bold statement only applies under certain conditions. It is to say, in a Modigliani-Miller world there are no agency costs, no bankruptcy costs and no taxes. Furthermore economic agents can count on perfect information and prices of assets correctly reflect all available information sources. In this case, opting for more debt financing, which is available at a lower cost than equity, increases the expected return for shareholders. But is also involves more risk for shareholders, which makes them demand higher returns, raising the cost of equity. No matter which debt ratio is chosen, the weighted average cost of capital therefor will stay the same, at least if the conditions previously mentioned apply.  Needless however to say that in the real world, these criterions do not hold. With respect to the existence of taxes, the M&M theorem can be adapted by taking into account the tax benefit of debt. In this case, the value of a company can be increased by adopting a higher debt ratio. But the effect of the other conditions is not as easy to estimate.

In fact, this is where the significance of the Modigliani-Miller theorem really lies. It is clear that in reality the necessary assumptions that are used, will probably never be valid, not even in France. But the theorem was never developed to ‘prove’ that financial structure is really irrelevant. Actually, by closely looking at how the theorem is affected when the imposed conditions are not fulfilled, one can understand the trade-off that exists between debt and equity financing in imperfect markets. It is this continuously evolving trade-off between benefits and costs created by market imperfections that constantly drives the optimal debt level of a company, for example through tax benefits and bankruptcy costs. Taking this into account, it is fairly safe to say financial managers today still take their decisions with Modigliani and Miller in mind.