Issuer Quality and Corporate Bond Returns

1. Issuer Quality and Corporate Bond Returns Robin Greenwood and Sam Hanson Harvard Business School QWAFAFEW Presentation: October 2013

2. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary The Credit Cycle • How does the quantity/quality of credit evolve over time? • Research in corporate finance and macroeconomics has emphasized time-varying financing frictions • Recent research hints that time-varying returns due to shifting investor sentimentmay also play a significant role: • Junk bond boom of the 1980s • Credit boom of the 2000s • Jeremy Stein of the Federal Reserve has suggested that the Fed should actively monitor the composition of issuance • This paper: Historically, what is the relationship between quantity/quality of credit and future investor returns?

3. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Quantity and Quality • Existing market-timing literature uses financing quantities to forecast returns • Firm-level stock returns: Loughran and Ritter (1995), Daniel and Titman (2006), Fama and French (2008) • Market-wide or factor-level stock returns: Baker and Wurgler (2000), Greenwood and Hanson (2010) • Why focus on the credit quality of debt issuers? • Firms borrow more when expected credit returns are lower • Broad changes in pricing of credit have a larger impact on the cost of debt for low quality firms (i.e., high default probability firms) • “Credit Beta” • Low quality issuance responds more to shifts in pricing of credit • → Movements in expected credit returns trace out variation in the average quality of debt issuers

4. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Overview • Construct time-series measures of corporate debt issuer quality. Use quality measures to forecast corporate bond excess returns. • Main finding: When issuers are of low quality, future excess corporate bond returns are low, and often significantly negative • Incremental forecasting power over various controls and the total quantity of corporate debt financing • What drives time variation in expected returns? • Countercyclical risk premia • Changes in the health of intermediary balance sheets • Excessive risk-taking due to agency problems: “reaching for yield” • Over-extrapolation by investors • Evidence of mispricing suggests #3 or 4 may be part of the story

5. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Empirical Strategy • Firms of differing credit quality choose debt issuance • Credit spreads: reflect expected losses and expected excess returns, both of which vary over time • Shifts in expected excess returns can reflect changes in rational price of risk, mispricing, or both • Firms:Issue more debt when expected returns are lower • But issuance is impacted by other factors (shifts in investment opportunities or target leverage) → issuance is a noisy reflection of expected returns • Identifying assumption: Expected excess returns on low quality bonds are more exposed to broad changes in the pricing of credit • e.g., if E[AAA return] falls by 10 bps, E[HY return] falls by 100bps →Low quality issuance responds more to broad shifts in credit pricing

6. Introduction Empirical StrategyIssuer Quality Forecasting Results Interpretation Summary Forecasting Returns w/ Quality, Quantity, and Spreads • Quantity = sum of issuance of low and high credit quality firms • Impacted by common shocks to factors unrelated to expected returns (shifts in investment opportunities or target leverage) • Quality = difference in issuance between low & high quality firms • Removes common shocks, better isolating movements in expected returns • Forecasting excess returns using quantityand quality: • Quality more informative than quantity if important common shocks unrelated to expected returns impact debt issuance of all firms

7. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Measuring Issuer Quality: ISSEDF • What is the default probability of firms with high vs. low debt issuance? • EDFi,t = Merton (1974) Expected Default Frequency, computed following Bharath and Shumway (2008) • Easiest to think of this as the difference in the “credit rating” between high and low debt issuers

8. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Measuring Issuer Quality: ISSEDF • ISSEDF is high when issuing firms are of poor credit quality

9. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Measuring Issuer Quality: ISSEDF • ISSEDF is high when issuing firms are of poor credit quality • ISSEDFcorrelated with business cycle, but removing macro variation doesn’t change basic character of series.

10. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Measuring Issuer Quality: ISSEDF • ISSEDF is high when issuing firms are of poor credit quality • ISSEDFcorrelated with business cycle, but removing macro variation doesn’t change basic character of series. Late-1960scredit boom Credit boom 1996-1998 1980s junk bond boom Credit boom 2004-2007 Penn Central1970 Junk bond bust1990-1991 Telecom bust 2001-2002

11. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Measuring Issuer Quality: High Yield Share

12. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Measuring Issuer Quality: High Yield Share 1962-1982: r(HYS,ISSEDF) = 0.47 1983-2008: r (HYS,ISSEDF) = 0.58

13. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Measuring Issuer Quality: ISSEDFvsHYS • Advantages of HYS • Simplicity • “Natural” to use bond issuance to forecast bond returns • Advantages ISSEDF • Combines all sources of debt financing → not impacted by secular shifts in the bond vs. loan mix → stationary series • If bonds/loans are partial substitutes, measures based on total debt issuance (loans+bonds) may be more informative about bond returns. • Credit rating standards have evolved over time: agencies became more conservative in the late 1970s • Based on net debt issuance as opposed to gross issuance

14. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Other data • Corporate bond returns by credit rating from Barclays (Lehman) and Morningstar (Ibbotson) • Cumulative k-year log excess returns: • Returns are in excess of Treasury bonds with comparable duration • Other controls: bill yield, term spread, macro controls, etc

15. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Issuer quality forecasts excess corporate bond returns • Figure 3, Panel A: • Economic magnitudes are significant: • 1-s increase in ISSEDF (0.48 deciles) → cumulative excess returns fall by 7.30 %-points over the following 2 years • Same results hold with HYS (Figure 3, Panel B)

16. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Issuer quality forecasts excess corporate bond returns • Table 2: Univariate forecasting regressions • Increasing coefficients up to 3-years, levels off after • Emphasize 2-year cumulative returns from here on • Stronger results for HY bonds. • Consistent with idea that ISSEDF reflects pricing of credit risk • Results hold even with number of interest rate and macro controls →Parallel results for HYS

17. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Quality and Quantity during Credit Booms • Measure aggregate credit growth using Compustat as DDt/Dt-1. Similar results using Flow of Funds data. r(DDAgg/DAgg,ISSEDF) = 0.45

18. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Quantity vs. Quality • Table 4: Panel A Quality beats Quantity in a horserace Credit growth of low quality firms is most useful for forecasting returns Differential debt growth of low vs. high quality firms is a strong predictor →Similar results for HYS

19. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary What drives time-variation in expected credit returns? • Rational consumption-based (integrated-markets) explanations: • Time-varying quantity of risk • Time-varying rational price of risk • Frictional account:Changes in intermediary capital → changes in risk premia • Agency problems: Low interest rates → “Reaching for yield” → Mispricing • Investors make expectational errors: • Extrapolation of recent outcomes → under/over-weight the probability of left-tail events → Mispricing

20. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Changes in the Rational Price of Risk • Counter-cyclical movements in price of risk as in representative agent consumption-based models • If markets are integrated, time-varying risk premia that are reflected in credit markets should also show up in equity markets

21. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Time-varying risk premia • A number of findings are consistent with these models: • ISSEDFis cyclical: High debt issuers have high EDFs in expansions • But ISSEDF remains a strong forecaster after controlling for macro variables • Results are strongest for lower-rated bonds which are more highly exposed to macroeconomic risk • Other findings cut against the integrated-markets view… • ISSEDF not useful for forecasting equity returns (Table 9) • ISSEDF predicts high yield excess returns after controlling for contemporaneous realizations of MKTRF or Fama-French factors

22. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Forecasting Reliably Negative Excess Returns • Consumption-based models: expected excess returns always > 0 • HY underperform USTs in “bad times” → expected excess returns > 0. • However, predicted excess returns are often significantly negative Figure 5, Panel B:

23. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Frictional Account: Intermediary capital • Fluctuations in intermediary balance sheets affect risk premia • Predict that issuer quality will be poor (i.e., ISSEDF will be high) when intermediary balance sheets are strong and risk bearing capacity is high • Look at several types of intermediaries: • Insurers: Largest holders of corporate bonds • Broker-dealers: Provide liquidity in corporate bond market • Banks: Provide a close substitute for bond financing • Measures of balance sheet strength: • Equity/Assets, Asset Growth, Bank Credit Losses

24. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Frictional Account: Intermediary capital • We run two types of regressions: • Regression 1: What is the relationship between ISSEDF and proxies for intermediary balance sheet strength Zt? • Frictional models predict: b > 0 • Regression 2: Do proxies for intermediary capital diminish the forecasting power of ISSEDF? • Frictional models predict: b2 < 0; magnitude of b1 should decline once we control for Zt

25. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Insurer balance sheets • Some evidence of a link between balance sheets and ISSEDF • But controlling for intermediary balance sheet variables does not have meaningful impact on forecasting power of ISSEDF • Similar conclusions for other intermediary variables (Results here→) • Frictional stories also inconsistent with negative expected returns Equity Capital, or Asset growth

26. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Agency-based Explanation: “Reaching for Yield” • Delegated institutional investors have incentives to reach for yield when interest rates are low or have fallen (Rajan 2005) • 2004-2007 credit market boom • Klarman (1991): 1980s junk bond boom • Possible stories: • Intermediaries with fixed liabilities have incentives to engage in risk shifting when nominal rates fall • Costly for pensions to reduce return targets → reach for yield • Fund managers compensated on basis of absolute nominal returns • Stories may admit the possibility of negative expected returns • Our analysis: • Investigate impact of yields and changes in yields on ISSEDF • But recall our baseline results already control for interest rates

27. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary “Reaching for Yield” • Table 11: Impact of yields and changes in yields on ISSEDF Levels 1-yr changes 2-yr changes → Similar results for HYS

28. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Investor-beliefs based explanation • Time-variation in expected returns may be due to mistaken investor beliefs about true creditworthiness of borrowers • Natural story: over-extrapolation • Wide variety of evidence on investor extrapolation • Investors use a “representativeness” heuristic • Intermediaries use backwards looking risk management systems (e.g., Value-at-Risk) → built-in tendency towards over-extrapolation

29. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Extrapolative Beliefs • Potential account : • Economy switches between good times in which few firms default, and bad times in which a higher fraction of firms default • Investors think economy either evolves via a more persistent process or less persistent process than truth (Barberis, Shleifer, Vishny 1998) • What happens? • A string of low-default realizations → investors become over-optimistic that good times will last → neglect down-side risks • If the high default state arrives → expectations are revised • If bad state persists → investors over-estimate default probabilities • Generates short-term return continuation, longer-term reversals • Add a corporate sector that levers up when debt is “cheap” • Growing optimism → borrower quality erodes • Spreads under-react to erosion in borrower quality in booms→ both quality and credit spreads forecast returns

30. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Extrapolative Beliefs • Consistent with negative expected excess returns ✓ • ISSEDF should be high following a string of low realized defaults or high returns on credit assets ✓ Levels 1-yr changes 2-yr changes → Similar results for HYS

31. Introduction Empirical Strategy Issuer Quality Forecasting Results Interpretation Summary Conclusions • Summary: • Issuer quality is low → future corporate bond excess returns are low • Evidence of mispricing: forecast significantly negative excess returns • 2004-2007 credit boom is not without precedent – part of a recurring historical pattern, dating to at least the 1940s • Interpretation: • Difficult to fully explain by appealing to rationally time-varying risk aversion or other rational drivers of counter-cyclical risk premia • Partially consistent with frictional and agency-based stories • Some evidence that over-extrapolation plays a role • Future work: • Micro empirical work on excessive risk-taking? Or mistaken beliefs? • Understand the real consequences of credit market booms • Quality of sovereign debt issuers