Asymmetric Information and Credit Quality: Evidence from Synthetic Fixed-Rate Financing

Abstract

This paper examines the usage of synthetic fixed-rate financing (SFRF) with interest rate swaps (i.e. borrowing short-term and using swaps to hedge interest rate risk, instead of selecting conventional fixed-rate financing) by Fortune 500 and S&P 500 nonfinancial firms over the period 1991 through 1995. We then monitor credit ratings, debt issuance, and debt maturities of these firms through 1999. We find strong evidence supporting the asymmetric information theory of swap usage as described by Titman (1992), even after controlling for industry, credit quality, size effects, and the simultaneity of the capital structure and the interest rate swap usage decision. Consistent with theoretical predictions, we find that SFRF firms are more likely to undergo credit quality upgrades. When limiting the sample to firms where asymmetric information costs are potentially the greatest, the results are even stronger. These findings are important because they document that swaps serve a highly valuable service for firms subject to information asymmetries.

Keywords: Interest rate swap, credit quality, asymmetric information, debt maturity, capital structure

JEL Classification: G30