Selected Journal Publications

26.04.2019

Public Bonds and Private Loans

The Effect of Bank Monitoring on Public Bond Terms
MA, Zhiming | STICE, Derrald | WILLIAMS, Christopher
Journal of Financial Economics

When designing bond contracts, bondholders should be aware that private lenders will likely have different preferences as borrowers enter financial distress, and are likely to design debt contracts differently when there are private loans to protect their interests.

Building on the extensive literature, a recent study by Ma, Stice, and Williams investigated the effect of bank loan monitoring on public bond contract design. Specifically, whether bond issuers who have recently obtained a private loan receive different bond contracts to those that have not. They also looked at how bondholders set contracts to utilize bank screening and monitoring while at the same time protecting themselves.

Using a sample of 5,939 bond issuances made by 3,901 firms between 1989 and 2013, the study determined whether each of these issuances was preceded by a private loan; and investigated the differences in bond contracts obtained by bond issuers with and without a bank loan. The effect of bank monitoring on non-price terms of bond contracts and the inclusion of debt covenants in bond contracts was also analysed.

Through a series of cross-sectional tests, the authors also looked at the conditions under which the influence of bank monitoring varies. First, the effect of monitoring based on the level of information asymmetry between the borrower and lenders was considered. Then it was determined whether the effect of bank monitoring differs with the expected likelihood of default by the borrower. Finally, the variation in private loan terms and firm age was examined.

Results showed that bond yield spreads are lower, and borrowed amounts are higher, when bond issuers have recently obtained a private loan. These bonds also include more covenants than those issued with the cross-monitoring of banks. It was discovered that bank monitoring is most valuable to bond issuers when information asymmetry between borrowers and lenders is high. Borrowers that are small, have low analyst following, or who have high stock return volatility, receive lower interest rates when they have recently obtained a private loan. Bondholders also take advantage of the extra monitoring of banks by including additional covenants.

Furthermore, the authors found that coordination between different types of debt-holders can be costly and increases financial distress. Results showed that the benefits of bank monitoring on bond contracts vary with the likelihood that a borrower will default on the loan or need to renegotiate the debt contract because of the default coordination costs. While riskier borrowers benefit most from the presence of bank monitoring, in terms of receiving lower bond interest yields, they have additional covenants included in their debt contracts. It was also determined that the effect of bank monitoring is greater when the bank loan amount is large or the maturity is long, and that bondholders include more covenants in the contracts of young firms.

Showing that the effects of bank monitoring are larger and more widespread than previously known, the relation between monitoring and bond contracting was found to vary based on a range of factors not previously studied. Overall, the findings suggest that borrowers with the flexibility to pre-empt their public bond issuances with private loan agreements receive significant benefits in their bond terms. However, these benefits come with increased monitoring by creditors.


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