IMPACT OF NEW DEBT OFFERINGS ON EXISTING CORPORATE BONDHOLDERS

• DOI: http://doi.org/10.1111/jfir.12157
• Date: 01 September 2018
• Published date: 01 September 2018

IMPACT OF NEW DEBT OFFERINGS ON EXISTING CORPORATE

BONDHOLDERS

Fan Chen

Pacific University

Duane R. Stock

University of Oklahoma

Abstract

Corporate bondholders may be concerned about the value of their bonds when the firm

issues more bonds. Using bond data from the Trade Reporting and Compliance Engine

(TRACE) from 2005 to 2017, we study the impact of new bond issues and relative

maturity on the price of existing bonds. We find negative and significant average

abnormal returns for existing bonds over a three-day event window. Consistent with the

adverse consequences of relative maturity of the new issuance, existing bond market

returns are more strongly negative when the newly issued bonds mature before existing

bonds. A funded debt covenant attenuates the negative return.

JEL Classification: G10, G14, G35

I. Introduction

U.S. corporations have long used large amounts of debt to finance their operations. The

amount of debt issued since the financial crisis is very high and worrisome to many.

According to the Federal Reserve, nonfinancial corporations owed $6 trillion in debt as of

late 2015.

1

More than $1.4 trillion of corporate bonds were issued in each of 2014, 2015,

and 2016, whereas in comparison, much less than $1 trillion was issued in 2009 and

earlier.

2

Since 2014, U.S. firms have raised much less from common equity issuances.

There are two strong reasons for existing bondholders to be concerned that this

unusually large amount of new bond issuance could have a negative impact on their

holdings. First, the firm may well be more levered because of the new debt issuance

where, as a result, wealth could be transferred from one claimholder to another.

Relatedly, a new bond issuance could be interpreted as a signal that cash flows are less

than expected. Second, a new bond issuance could particularly threaten existing bonds if

This article was nominated for a best paper award at the Financial Management Association (FMA) meetings

in 2016 (Las Vegas). We thank Tor-Erik Bakke, Louis Ederington, Chitru Fernando, Hamed Mahmudi, Seth

Hoelscher, Scott Linn, William Megginson, Ashley Newton, Philip Valta, Pradeep Yadav, and seminar participants

at the 2014 European Finance Association meetings, 2016 FMA annual meeting, SUNY Oneonta, University of

Oklahoma, and Utah Valley University. Fan gratefully acknowledges financial support from the Allen-Rayonier

foundations at the University of Oklahoma. We remain responsible for all errors.

1

https://fred.stlouisfed.org/series/NCBDBIQ027S

2

https://www.sifma.org/resources/archive/research/statistics/

The Journal of Financial Research Vol. XLI, No. 3 Pages 383–410 Fall 2018

DOI: 10.1111/jfir.12157

383

© 2018 The Southern Finance Association and the Southwestern Finance Association

the new bond is of short maturity and matures before the existing bonds wherein the

newer bond, but not the existing bond, could be redeemed on schedule. More specifically,

when a new bond (of equal contractual priority) has a shorter maturity than existing

bonds, the existing bonds may effectively become subordinated to the new bond. This

effect, due to the new bond being redeemed before existing bonds, may well lead to a

negative effect at the offering announcement for existing longer maturity bonds of the

same firm. Several research articles have elaborated on the potential for a new short-

maturity issuance to be harmful to existing longer term maturities of the same firm. We

elaborate on these articles later.

In contrast, when a new bond has a longer maturity than existing bonds, one may

logically suggest that the existing bonds effectively become senior to the new bond. In

this case, the new bond increases the quantity of assets available to service the existing

debt. This potentially valuable effect may reduce the default risk exposure of existing

long-maturity bonds.

The purpose of our research is to empirically examine how bond prices react to

new bond issues in the context of the effects of wealth distributions to different claimants,

signaling, and relative maturity. Although our main focus is the impact on bondholders,

for completeness, we also report the impact on equity (stock returns), as some hypotheses

concerning bond behavior are obviously strongly related to equity behavior.

Our results are that existing bonds of the same firm are negatively affected upon

issuance of new debt where this result is robust to alternative windows surrounding the

new debt issuance. This impact on existing bonds is consistent with a wealth transfer

given that equity returns for the same firm are positive and marginally significant. The

wealth transfer results are particularly strong when the intended use of funds is a stock

repurchase. Another important result is that new issuances of a short maturity relative to

existing bonds have a negative impact on the valuation of existing bonds.

We note that any effects of a new bond issuance may well depend on the intended

use of funds and the effectiveness of any protection provided (or not) by different bond

covenants; therefore, we analyze such factors. In regard to covenants, Billett, King, and

Mauer (2007) find that debt covenants can mitigate agency costs because the association

between leverage and growth opportunities becomes less negative via covenant

protection.

3

It is important to analyze the potential protection that covenants provide

existing bondholders upon the issuance of new debt. As an example, we find that the

negative impact on existing bond market valuation when the new issuance maturity is

shorter than existing bonds of the same firm is significantly attenuated by funded debt

covenant protection.

Other research has addressed alternative questions concerning bond issuance. To

illustrate the uniqueness of our research, we compare our work to Maxwell and Stephens

(2003) and Linn and Stock (2005). Maxwell and Stephens examine the impact of stock

repurchases on existing bonds and stocks of the issuing firm. However, in contrast to our

work, they do not address the impact of bond issuances on existing bonds and stocks. The

3

Nash, Netter, and Poulsen (2003), Goyal (2005), and Reisel (2014) examine the determinants of covenants in

public debt issues, whereas Dichev and Skinner (2002) and Bradley and Roberts (2015) examine the determinants

of covenants in private debt issues.

384 The Journal of Financial Research