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Monetary policy, reach-for-yield and small-versus-large company debt maturity adjustments

The figure reports the impulse response function of the share of long-term debt to a 25 basis points policy rate cut across different groups of non-financial listed companies, sorted according to industry-level asset size quartiles.

Why do such big, arguably unconstrained companies increase long-term debt and change their debt maturity structure when monetary policy loosens?

We propose a theory that encompasses firm-level financing frictions due to moral hazard and the presence of yield-seeking investors (Hanson and Stein 2015) who reach for yield, meaning that they increase demand for risky long-term bonds when the policy rate falls, to maintain their portfolio yield. Only large, unconstrained companies can take advantage of this demand shift by issuing long-term bonds, in line with our empirical facts.

Our work concludes with few empirical tests on the model’s main mechanism. In particular, in line with our theory, we find that reaching for yield by corporate bond mutual funds (Choi and Kronlund 2018) is associated with a larger jump in corporate bond holdings and a boost in portfolio maturity following an interest rate loosening. Likewise, in line with the prediction that large firms’ relative response is driven by increase in demand by financial investors, we find not only that large firms increase the issuance of long-term bonds, but also such issuance benefits from relatively lower financing costs (compared with small firms).

Policy implications

Our work has the following policy implications:

  • Prolonged periods of low interest rates have the unintended consequence of piling up huge amounts of long-term debt in large firms’ balance sheets, with potentially serious debt overhang dynamics as a legacy (Gomes et al. 2016; Kalemli-Ozcan et al. 2018).
  • The reach-for-yield channel favors large firms, which dominate the bond market and are unlikely to increase investment and/or employment through the debt channel  (see, for example, Elgouacem and Zago 2019). Hence, this channel may not have significant effects on the real economy.
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    Most advanced economies have experienced very low interest rates over the past decade. Given the unprecedented contractionary forces released by the Covid-19 pandemic, low rates are likely to remain for the foreseeable future. While in this policy environment the traditional bank-centered monetary policy transmission may be hampered (see, for example, Brunnermeier and Koby 2018), the reach-for-yield channel is likely to be exacerbated, which ultimately raises doubts about the effectiveness of further monetary expansion in stimulating recovery. 

    We leave this question for future research.

    Andrea Fabiani (@AndreaFabiani89) is a PhD candidate in Economics at Universitat Pompeu Fabra & Barcelona GSE. More details about his research can be found on his website.

    References

    Brunnermeier, M. K., & Koby, Y. (2018). The reversal interest rate (No. w25406). National Bureau of Economic Research.

    Choi, J., & Kronlund, M. (2018). Reaching for yield in corporate bond mutual funds. Review of Financial Studies, 31(5), 1930-1965.

    Elgouacem, A., & Zago, R. (2019). Share Buybacks, Monetary Policy and the Cost of Debt (No. w773). Banque de France.

    Fahlenbrach, R., Rageth, K., & Stulz, R. M. (2020). How valuable is financial flexibility when revenue stops? Evidence from the Covid-19 crisis (No. w27106). National Bureau of Economic Research.

    Gomes, J., Jermann, U., & Schmid, L. (2016). Sticky leverage. American Economic Review, 106(12), 3800-3828.

    Greenwood, R., Hanson, S., & Stein, J. C. (2010). A gap‐filling theory of corporate debt maturity choice. Journal of Finance, 65(3), 993-1028.

    Gürkaynak, R. S., Sack, B., & Swansonc, E. T. (2005). Do actions speak louder than words? The response of asset prices to monetary policy actions and statements. International Journal of Central Banking.

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    Hanson, S. G., & Stein, J. C. (2015). Monetary policy and long-term real rates. Journal of Financial Economics, 115(3), 429-448.

    Jarociński, M., & Karadi, P. (2020). Deconstructing monetary policy surprises—The role of information shocks. American Economic Journal: Macroeconomics, 12(2), 1-43.

    Jordà, Ò. (2005). Estimation and inference of impulse responses by local projections. American Economic Review, 95(1), 161-182.

    Kalemli-Ozcan, S., Laeven, L., & Moreno, D. (2018). Debt overhang, rollover risk, and corporate investment: Evidence from the European crisis (No. w24555). National Bureau of Economic Research.

    Source : blogs.worldbank.org

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