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 are valuable but alter the relative cost of bond financing across firms and over the business cycle. The theory builds on the assumption that information frictions prevent these agencies from rating firms correctly all of the time. Under these conditions, the cost of bond financing becomes dependent on the state of the economy and the quality of the signal provided by these agencies' ratings. As a result, when the mix of bond issuers becomes riskier, as happens in recessions, bond financing becomes more expensive for mid-quality firms. Bond financing may even become more expensive to all firms in which case mid-quality firms will be subject to the largest cost increase. The analysis of the bonds issued in the last two decades by American firms shows that split ratings, our proxy for the quality of the rating agencies' signal, 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.

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

JEL Classification: E44, G32