In their new paper “Debt Refinancing and Equity Returns,” published online in the Journal of Finance, Florian Nagler, Assistant Professor of Finance at Bocconi University, Milan, Niels Friewald (Norwegian School of Economics) and Christian Wagner (WU Vienna University) investigate one of the fundamental notions of corporate finance, that is, how debt affects stock returns.
They find that the traditional view that investors demand a premium for holding the stock of more highly levered firms could be expanded by considering the maturity structure of debt and not only the overall level of indebtedness.
Nagler and colleagues first classify debt in short-term (maturity under three years) and long-term (all other maturities) and then show that the ratio of short-term leverage to total leverage, called refinancing intensity, predicts returns.
The authors find that the yearly returns of high refinancing intensity firms are on average 2% higher than those of the low intensity ones. By contrast, companies that are merely highly leveraged do not exhibit a significant premium, reinforcing the hypothesis that it is short-term debt, rather than debt itself, that investors want to be compensated for.
The analysis is then repeated, sorting the firms based on size, short-term and long-term leverage, this time looking at the maturity and level of debt jointly. The results are similar, with the long-term leverage premium insignificant again.
Because investors can diversify their holdings, they want to be compensated for owning the stock of firms that have high systemic risk. The authors, therefore, look at some well-known asset pricing models (q-factor, Fama and French 3, Fama and French 5). The results show that refinancing intensity and short-term leverage are indeed correlated with systemic risk. Higher risk prompts investors to demand a discount when buying shares of firms, making it more expensive for riskier firms to finance themselves by selling equity.
The last part of the paper explores in detail the interaction between short-term leverage and systemic risk through a model. It results that firms with high systemic cashflow risk benefit from raising relatively more short-term debt, because it reduces the liquidity costs in the secondary market that come with long-term debt. While short-term leverage reduces liquidity costs, it also entails refinancing risk, not knowing at which interest rate the next batch of debt will be raised. Thus, investors demand a return premium to buy shares of short-term debt financed companies.
“The model at the end of the article was actually the core of the original paper,” says Prof. Nagler. “The topic is big and can be looked at from many perspectives. Now the paper focuses on the empirical part and on the corporate financial implications, that is, to show how the debt maturity structure interacts with the cost of equity. The model now only helps to guide the interpretation of the results. From this point, there is huge potential for research in other fields, like asset pricing and macro-finance.”
Nils Friewald, Florian Nagler, Christian Wagner, “Debt Refinancing and Equity Returns,” published online before inclusion in an issue, Journal of Finance. DOI: https://doi.org/10.1111/jofi.13162.