Are Financial Constraints Priced? Evidence from Firm Fundamentals, Stocks, and Bonds

Abstract:     
This paper examines the real and financial implications of credit market imperfections. It does so using detailed firm-level data. Under alternative measures of financing constraints, we first show that financially constrained firms' business fundamentals (e.g., operating earnings and capital expenditures) are systematically more sensitive to aggregate economic movements than unconstrained firms' fundamentals. We then show that financial constraint "factors" have significant explanatory power over equity returns. Crucially, those return factors covary with macroeconomic movements exactly as suggested by the theory: the difference between the stock returns of financially constrained and unconstrained firms widens precisely when financial constraints are more likely to bind (when aggregate credit conditions are tight). Because a firm's stocks and bonds are claims written on the same real production process, we also look for evidence on financial constraints in the pricing of debt securities. We find that financially constrained firms' bonds command higher ex ante risk premia in virtually every month of the last three decades. Moreover, these ex ante risk premia, too, covary with macroeconomic movements in a fashion that is consistent with the effect of financial constraints on real firm behavior: the constraint risk premia are counter-cyclical. The evidence we gather from firm fundamentals, stocks, and bonds indicate that financial constraint is a systematic, priced risk.

Keywords: Financial constraints, equity returns, credit spreads, systematic risk, macroeconomic shocks

JEL Classifications: G12

Working Paper Series