Aurora Borealis
1 May 2015 CFA Institute Journal Review

Debt Maturity Structure and Credit Quality (Digest Summary)

  1. Marc L. Ross, CFA

Investigating the impact of a firm’s ability to satisfy its credit obligations on its overall credit quality, the authors find that firms with more exposure to rollover risk have lower credit quality and that long-term bonds issued by those firms trade at higher yield spreads.

What’s Inside?

The authors study the effect of a company’s ability to manage its maturing debt on its creditworthiness and find a positive correlation between the two factors. This degradation of credit quality worsens in speculative-grade issuers as well as companies with decreasing profitability. The impact of recessions also exacerbates the situation.

How Is This Research Useful to Practitioners?

Recent high-profile collapses of financial firms during the Great Recession, along with a substantial body of theoretical research that makes a case for the presence of increased risk with a firm’s inability to settle maturing debt, motivate the authors to investigate the phenomenon of rollover risk as an additional source of credit risk.

A rigorous examination of the empirical evidence supports the authors’ hypotheses—namely, that firms subject to greater rollover risk have lower credit quality and that such firms face higher borrowing costs as a consequence, all else being equal. The data span a 24-year period and include only pure expressions of a firm’s credit quality, scrubbed of any optionality and features that would affect the firm’s overall creditworthiness. The authors take a close look at firm financials and, in particular, capital structure to arrive at the assessment. Various robustness tests confirm their findings.

Fixed-income analysts and portfolio managers would find the conclusions from this research a useful complement to their assessment of credit instruments—so, too, would merger and acquisition specialists and industry trade buyers in their evaluation of potential acquisitions.

How Did the Authors Conduct This Research?

To conduct their empirical analysis, the authors consider the period 1986–2010, using Standard & Poor’s (S&P) ratings of firms’ overall long-term credit quality rather than assessments of specific company bond issues. Monthly data are from Compustat, and the authors rank the data using an ordinal best-to-worst ranking system from 1 to 22. Supplementing these data are annual firm financials, also from Compustat, along with stock performance from CRSP and information on long-term corporate bonds taken from the Mergent Fixed Income Securities Database. The authors filter the latter sample to create a dataset representative of the general market, excluding speculative-grade issues, variable rate credits, and any bonds with optionality, convertibility, or credit enhancements.

The authors test their hypotheses using such critical variables as the change in that portion of a firm’s long-term debt due within a year, changes in its S&P rating, changes in up- or downgrades, and changes in the yield spread on its long-term bonds to measure borrowing costs. Multivariate analysis is used to test the two hypotheses. For the first, the authors perform a regression analysis that accounts for such firm characteristics as size, leverage, profitability, growth, operating risk, and asset composition and for how these characteristics affect the amount of long-term debt due within a year. The greater the rollover risk, the lower the firm’s creditworthiness, all else being equal. They also determine that increases in ratings downgrades, rather than decreases in upgrades, drive the results—namely, that firms with larger amounts of long-term debt due within a year are more susceptible to rating agency downgrades. These results are robust to tests for the nonlinear effect of long-term debt payable on credit quality and for firm exposure to rollover risk measured in lags of up to five years out rather than one year.

For the second hypothesis, the authors run regressions to test whether yield spreads on a firm’s bonds change by year-end in anticipation of the firm’s changing exposure to rollover risk and whether a firm’s creditworthiness changes during the year in which it experiences a change in rollover risk. They control for other factors that could affect bond yield changes, including volatility of excess return, market capitalization, long-term debt to book value, operating income to sales, and identifiers of low interest coverage. Firms with rollover risk from maturing long-term debt increase their credit risk independently of their credit rating.

Abstractor’s Viewpoint

Rollover risk is not an insignificant consideration in the evaluation of a firm’s creditworthiness. A company’s inability to meet larger long-term obligations payable within a year negatively affects its creditworthiness and results in higher yields. For firms with speculative-grade ratings and decreasing profits, these effects are more acute, just as they are during prolonged economic downturns. Rating agencies appear to have inadequately factored rollover risk into the bigger picture of credit risk—tacit acknowledgment of which agencies actually published during the height of the recent financial crisis. Further research could support or refute any tentative conclusions.

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