Corporate credit and business cycles

Bo Becker Stockholm School of Economics and NBER

Corporate credit

• Important to firms

• Important to investment in new physical and intangible capital

• Important to investors (households, retirement savings, insurance industry, banks)

Corporate credit is cyclical: US

1 7 13 19 25 31 37 43 49-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

Growth of stock of corporate debt

Source: US Flow of FundsNBER Recessions

Corporate credit is cyclical: Europe

Source: Mario Draghi, ”Euro area economic situation and the foundations for growth”, March 14, 2013

Reason for cyclicality

What happens in bad times

Implications for fiscal and monetary policy

Demand is cyclical Firms don’t want to invest

Support firms (not banks)

Supply is cyclical Banks are constrained, won’t lend (Holmström Tirole 1997)

Non-standard measures that support bank equity/lending= Government investment in banks such as TARP

Matching frictions are cyclical

Harder to separate good from bad credit risks, or firms lack equity to support borrowing (Bernanke and Gertler 1989)

?

Reasons for cyclicality

Friction cyclicality – what does the evidence say?

• Market frictions- Information or agency

• [Information] Worse lemon problems in borrowing market- Banks have considerable information at all times- Perhaps not that important?

• [Agency] Not much direct evidence- Curious, since Bernanke-Gertler is standard reference

Demand cyclicality – what does the evidence say?

• Obvious mechanism: firms wish to invest less in bad times, need less funding

• Evidence is supportive- Even the least constrained firms in the economy tend to invest less in

recessions

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0% Ex: Wal-mart capital expenditure over assets, 4Q

Supply cyclicality – what does the evidence say?

• Kashyap, Stein and Wilcox (1993) showed that US firms issue more commercial paper and borrow less from banks in bad times- But not the same set of firms borrow through time (Kashyap and

Stein 1999)- Could be there are large firms (CP) and small firms (loans)- In bad times, large firms do bigger share of investment

• To address, need to keep firms fixed: compare same firm through time

• Becker Ivashina (JME, fothc.) compares bonds and syndicated loans issued for large US firms 1991-2011- Bond market acts as thermometer for banks- A given firm often gets a loan in good times, issues bonds in bad

times

Lending more volatile than bond issuance

Source: Becker Ivashina (2013 European Financial Review)

Also true in Europe

Source: Becker Ivashina (2012 European Financial Review)

“I am skeptical that one can say much about time variation in the pricing of credit--as opposed to equities--without focusing on the roles of institutions and incentives. The premise here is that since credit decisions are almost always delegated to agents inside banks, mutual funds, insurance companies, pension funds, hedge funds, and so forth, any effort to analyze the pricing of credit has to take into account not only household preferences and beliefs, but also the incentives facing the agents actually making the decisions. And these incentives are in turn shaped by the rules of the game, which include regulations, accounting standards, and a range of performance-measurement, governance, and compensation structures.”

Jeremy Stein, Feb 7, 2013

Why is supply of loans cyclical?

Why is supply of loans cyclical?

• Household preferences and beliefs- Irrational behavior- Animal spirits- Incomplete information

• Rules of the game- Regulation- Accounting standards- Performance-measurement- Governance- Compensation structures

Reaching-for-yield

“…looking for seemingly safe but higher-yielding debt-like securities”

Raghuram Rajan, 2010, Fault Lines

“[A] sustained period of very low and stable yields may incent a phenomenon commonly referred to as ‘reaching for yield,’ in which investors seek higher returns by purchasing assets with greater duration or increased credit risk”

Janet Yellen, 2011

“ fairly significant pattern of reaching-for-yield behavior emerging in corporate credit”

Jeremy Stein, 2013

Reaching-for-yield in insurance portfolios

NAIC 1 (AAA-A)

NAIC 2 (BBB)

NAIC 3 (BB) NAIC 4 (B) NAIC 5 (CCC)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

• US insurers focus on safe corporate bonds

• In part, response to capital requirements: lower risk = less capital

• Within a capital bucket, more of risky bonds

• Reach for yield- Build up of risk in

good times- May add to

cyclicality

0.3%Cap. req.: 0.96% 3.39% 7.38% 16.96%

Insurers’ acquisitions of new corporate bonds pre-crisis

Insurers’ acquisitions of new IG corporate bonds pre-crisis

Source: Becker Ivashina (2013, accepted Journal of Finance)

Yield spread55%

60%

65%

70%

75%

80%

85%

90%

1 (safest)

2

3

4 (riskiest)

Reaching for yield exacerbates credit cycles

Loading up on risk in good times

Stepping back in crisis

Appetite comes back

Source: Becker Ivashina (2013 Credit Flux)