This is a summary of "Testing the Credit-Market-Timing Hypothesis Using Counterfactual Issuing Dates," by Murray Z. Frank and Mahdi Nezafat, published in the Journal of Corporate Finance.
The authors test whether issuers can time when they issue debt in the short term—in particular, whether the risk-free rate and credit default swap (CDS) spread are lower on issue dates than they are around issue dates. They find evidence that bond issuers can successfully time the risk-free rate and CDS spread, in that these rates and spreads are relatively lower on issue dates. The authors find a statistically and economically significant gain from the timing of the risk-free rate of 8 bps and CDS spread of 12 bps.
What Is the Investment Issue?
The authors investigate whether bond issuers can time the credit markets. For bond issuers, this means whether issuers can issue bonds on a day when the risk-free rate or credit default swap (CDS) spread is relatively low. To test their hypothesis, the authors compare the risk-free rate and CDS spread on the issuance date with the risk-free rate and CDS spread on days around the issuance date. This methodology allows the authors to focus on the short-term market-timing ability of the issuers and helps them avoid issues with long-term market-timing tests.
How Did the Authors Conduct This Research?
The authors obtain bond data from 1985 to 2017 from the Mergent Fixed Income Securities database. They obtain risk-free rates from the Federal Reserve Economic Data database of the Federal Reserve Bank of St. Louis, and they also consider five-year CDS data from 2001 to 2015 from standard sources. Their sample excludes two general types of fixed income instruments. First, because of a lack of data in the Mergent database, the sample excludes commercial paper. Second, medium-term notes are excluded because they are sold over an extended period of time, which means that no single issue date exists on which the authors can perform their test.
The authors then test two notions of credit market timing: market level and firm level. For the market-level test, the authors analyze whether issuers issue bonds when investors are temporarily amenable to investing on especially good terms from the firm’s perspective. They do this by analyzing whether the 10-year US government bond rate, which is a measure of the risk-free rate, on the issue date is lower than the risk-free rate around the issue date. For the firm-level test, the authors analyze whether the issuer might opt to issue when the market is overestimating the firm’s creditworthiness. They do this by analyzing whether the CDS spread on the issue date is lower than the CDS spread around the issue date. In other words, the authors test to see whether the issue date is “exchangeable” with other days around the issue date. If the issue date is not exchangeable because the issue date has a lower risk-free rate or CDS spread, the authors take that as evidence of the issuer’s ability to time the credit market.
The authors choose a window with the same number of days before and after the issue date. They then construct a metric that is equal to the difference between the risk-free rate or CDS spread on the date of issuance and the average risk-free rate or CDS spread on days around the issue date. If the issuer can time the market, this metric would be expected to be negative.
To test the statistical significance of this metric, the authors use a permutation test, a nonparametric test that uses Monte Carlo sampling to create a distribution that represents the population of all possible permutations of each issue date within the dates in its associated window.
What Are the Findings and Implications for Investors and Investment Professionals?
Issuers appear to be able to time when they issue bonds. This implies that the issuers may be able to choose market conditions that are materially different from those around the issuing dates. The authors ascertain that, on average, issuers have a statistically significant gain of 8 bps from timing the risk-free rate and of 12 bps from timing the CDS spread.
Investors are more concerned about the economic significance of these gains. To put the economic significance of these gains into perspective, the authors apply these gains to the average offering size in their sample. For the risk-free rate test, the average offering amount is $408 million, so an 8 bp gain results in an average gain of approximately $325,000. For the CDS spread test, the average offering amount of bonds with CDS contracts available is $665 million, so a 12 bp gain results in an average gain of approximately $800,000.