Why Firm Access to the Bond Market Differs Over the Business Cycle: A Theory and Some Evidence

Abstract

This paper presents a theory of firm access to the bond market in which information gathering agencies provide a valuable service but alter the relative cost of this funding source across firms of different creditworthiness and over the business cycle. The theory builds on two assumptions. First, the "quality" of the signal produced by the information agencies that firms use to access this market varies with firms' creditworthiness. Second, the mix of bond applicants in recessions is riskier than in expansions. According to this paper's theory, rating agencies affect the cost to access the bond market and recessions increase the impact that these agencies have on the cost of this funding source. Importantly, the impact of recessions is not uniform across firms. It may, for instance, be largest for mid-credit quality firms. The analysis of the bonds issued in the last two decades by American nonfinancial firms produces evidence in support of the model's key assumption. I find that rating agencies are more likely to produce split ratings at issue date, my proxy for the "quality" of the signal produced by information agencies, on bonds of mid-credit quality issuers. The analysis of bond-credit spreads at issue date, in turn, shows that split ratings do not affect the relative cost of bond financing across firms in expansions, but they do increase the relative cost of this funding source for mid-credit quality issuers in recessions. Furthermore, this analysis shows that split ratings make bond financing more expensive for these mid-credit quality issuers in recessions than in expansions. These findings confirm the model's key result that information gathering agencies influence access conditions to the bond market across firms and over the business cycle. They also suggest that recessions alter the substitutability between bank funding and market funding, and that the extent of this effect is largest for mid-credit quality firms. This has several potentially important implications, in connection, for example, with firm choices of funding sources, bank lending policies and the credit channel of monetary policy.

Keywords: Business cycles, bond financing, bond spreads, credit ratings

JEL Classification: E44, G32