Short Term Debt Comes with a Penalty in the Cost of Equity
FINANCE |

Short Term Debt Comes with a Penalty in the Cost of Equity

RESEARCH BY FLORIAN NAGLER SHOWS THAT INVESTORS ASK FOR HIGHER RETURNS WHEN THEY BUY STOCK OF FIRMS WITH A HIGHER PROPORTION OF SHORT TERM DEBT. LONG TERM DEBT DOES NOT HAVE THE SAME EFFECT

A new study finds that investors want to be compensated, in the form of higher returns, for holding the stock of firms that have a relatively higher proportion of short-term debt, rather than long term debt
 
In their new paper “Debt Refinancing and Equity Returns,” published online in the Journal of Finance, Florian Nagler, Assistant Professor of Finance at Bocconi, Niels Friewald (Norwegian School of Economics) and Christian Wagner (WU Vienna University) investigate one of the fundamental notions of corporate finance, that is, how debt affects stock returns.
 
They find that the traditional view that investors demand a premium for holding the stock of more highly levered firms could be expanded by considering the maturity structure of debt and not only the overall level of indebtedness.
 


Nagler and colleagues first classify debt in short-term (maturity under three years) and long-term (all other maturities) and then show that the ratio of short-term leverage to total leverage, called refinancing intensity, predicts returns.
 
The authors find that the yearly returns of high refinancing intensity firms are on average 2% higher than those of the low intensity ones. By contrast, companies that are merely highly leveraged do not exhibit a significant premium, reinforcing the hypothesis that it is short-term debt, rather than debt itself, that investors want to be compensated for.
 
The analysis is then repeated, sorting the firms based on size, short-term and long-term leverage, this time looking at the maturity and level of debt jointly. The results are similar, with the long-term leverage premium insignificant again.
 
Because investors can diversify their holdings, they want to be compensated for owning the stock of firms that have high systemic risk. The authors, therefore, look at some well-known asset pricing models (q-factor, Fama and French 3, Fama and French 5). The results show that refinancing intensity and short-term leverage are indeed correlated with systemic risk. Higher risk prompts investors to demand a discount when buying shares of firms, making it more expensive for riskier firms to finance themselves by selling equity.
 
The last part of the paper explores in detail the interaction between short-term leverage and systemic risk through a model. It results that firms with high systemic cashflow risk benefit from raising relatively more short-term debt, because it reduces the liquidity costs in the secondary market that come with long-term debt. While short-term leverage reduces liquidity costs, it also entails refinancing risk, not knowing at which interest rate the next batch of debt will be raised.  Thus, investors demand a return premium to buy shares of short-term debt financed companies.
 
“The model at the end of the article was actually the core of the original paper,” says Prof. Nagler. “The topic is big and can be looked at from many perspectives. Now the paper focuses on the empirical part and on the corporate financial implications, that is, to show how the debt maturity structure interacts with the cost of equity. The model now only helps to guide the interpretation of the results. From this point, there is huge potential for research in other fields, like asset pricing and macro-finance.”
 
Nils Friewald, Florian Nagler, Christian Wagner,Debt Refinancing and Equity Returns,” published online before inclusion in an issue, Journal of Finance. DOI: https://doi.org/10.1111/jofi.13162.
 

by Pietro Vacca
Bocconi Knowledge newsletter

News

  • The Star That Makes Algorithms Work Better

    A new paper tackles the topic of the shape of the solution space and marks a leap forward in understanding how to design faster and more accurate algorithms  

  • Breaking Barriers: Gender Lens Investing reshaping financial landscapes

    Innovative research explores role of gender lens investing in sustainable growth  

Seminars

  December 2023  
Mon Tue Wed Thu Fri Sat Sun
        1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 27 28 29 30 31

Seminars

  • Francesco Decarolis - Competition in Digital Markets

    FRANCESCO DECAROLIS - Bocconi

    Alberto Alesina Seminar Room 5.e4.sr04, floor 5, Via Roentgen 1

  • Unsplittable Flow on a Path Joint work with Tobias Mömke and Andreas Wiese

    FABRIZIO GRANDONI - Istituto Dalle Molle di Studi sull'Intelligenza Artificiale

    Room 3-E4-SR03