Debt Contracting When Borrowers Face Transitory Uncertainty: Evidence from U.S. Gubernatorial Elections
43 Pages Posted: 31 Jul 2019 Last revised: 7 Oct 2021
Date Written: September 2021
We show that policy uncertainty surrounding U.S. gubernatorial elections has an important impact on loan pricing that can go unnoticed. In gubernatorial election years, loan contracts are more likely to include performance-pricing provisions, whereas loan spreads are mostly unaffected, consistent with efficiency of loan contracting under transitory uncertainty. Only among the loans without performance-pricing provisions, a marginal increase in loan spreads (1 to 4 bps) in election years and an increased demand for loan-spread amendments post-election are observed, suggesting that performance-pricing provision curbs an explicit rise in loan spreads. Furthermore, an important pricing effect is manifested through interest-rate contingencies in pricing grids. The use of rate-increasing grids rises in election years for the borrowers with geographically concentrated operations, high government contract-dependence, high political risk and high distress risk, indicating that loan contracts are designed to ensure compensation to lenders for uncertainty via interest-rate contingencies. Overall, our findings suggest that corporate borrowers facing election uncertainty make a dynamic tradeoff between a rise in the cost of loans at origination and the possibility of a cost increase in the future pursuant to state-contingent pricing rules.
Keywords: uncertainty, gubernatorial election, debt contract, contingency pricing, cost of capital
JEL Classification: G30, G39
Suggested Citation: Suggested Citation