The role of credit ratings in determining capital structure: an empirical analysis of UK non-financial firms

This thesis examines the role played by credit ratings in explaining corporate capital structure choice during a period characterized by a major adverse loan supply shock. Recent literature has argued that supply–side factors are potentially as important as demand–side forces in determining corporate leverage. This is based on the premise that debt markets are segmented and that those firms that have access to the private debt markets do not necessarily have access to the public debt markets. The question of access to debt finance has become a major issue for public policy makers in several developed economies during the 2007-2009 financial crisis. The UK economy has been subjected to a period of severe tightening of credit market conditions resulting in a significant reduction in the availability of bank credit to the corporate sector. An important question is whether the contraction in the flow of bank credit to firms has affected firms equally or whether firms with access to alternative sources of debt finance have been able to mitigate the effect of adverse changes to the cost and availability of bank credit. To investigate this issue, this thesis employs data over a 20 year period that includes two recessions and three noticeable periods of credit market tightening. Despite the fact that a severe recession has accompanied the 2007-2009 financial crisis we argue that the underlying forces driving the weakness in bank lending to the corporate sector are mainly supply side rather than demand side factors. In this thesis we use the possession of a credit rating as an indicator of access to the public debt markets. This thesis attempts to examine the relationship between credit ratings and capital structure of UK non-financial firms over the period from 1989 to 2010. The thesis consists of three empirical chapters, chapters 4, 5 and 6, each of which provide distinct and unique empirical evidence on the impact of possessing a credit rating on the capital structure decision of a large sample of UK non-financial firms. Chapter 4 examines whether the possession of a credit rating has an impact on a firm's leverage ratio. Until recently the primary focus of the majority of previous empirical studies on capital structure choice was the demand side determinants of leverage, while little attention has been given supply side factors that might open up access to alternative sources of debt capital. The issue of access to alternative sources of debt capital has received special attention in the wake of 2007-2009 financial crisis when banks significantly cut back on loans and many firms without access to public debt market, became credit-constrained. A credit rating benefits firms not only by providing access to local public bond markets, but having a rating from one of the major agencies (S&P or Fitch) gives an opportunity to issue bonds in the international debt capital markets. For U.K. firms this is especially important, since a rating can “open the door” to the U.S. capital market – the largest and most liquid source of debt capital. The empirical analysis in this chapter utilises data over a 22 year period from 1989 to 2010. In line with recent empirical literature (Faulkender & Petersen, 2006; Kisgen, 2007; Leary, 2009) public debt market access is measured by the possession of a credit rating and firm size dummies. Using both pooled OLS and panel regression techniques the results in this chapter indicate that firms with access to public debt markets have higher leverage ratios after controlling for demand-side determinants of capital structure. The empirical results demonstrate that supply side factors are an important determinant of capital structure choice for UK non-financial firms. The results suggest that for the full sample of firms the possession of a rating increases leverage by around 4 per cent for UK firms over the period 1989 through to 2010. When we restrict our sample to rated firms and those in the bottom 30 per cent of the firm size distribution the effect of having a rating on leverage is much greater, with the rating coefficient ranging between 5.7 and 7.2 per cent. When we control for endogeneity of having a rating our results remain qualitatively similar. After instrumenting for having a rating we find that the coefficient is around 5.5-6.7 per cent. When controlling for self-selection bias we find that rated firms have around 5 per cent higher leverage. The chapter provides empirical evidence in support of the hypothesis that the possession of a credit rating is associated with higher leverage ratios. The results are robust to the methods of estimation and controlling for endogeneity between possessing a credit rating and leverage. The empirical analysis in chapter 5 extends the work of Faulkender & Petersen (2006) and Leary (2009) by controlling for the effect of credit quality when examining the relationship between having a credit rating and the leverage ratio. In this chapter we examine whether the positive relationship between having a credit rating and the leverage ratio in Chapter 4 is driven by the potential reverse causality between credit quality and the leverage ratio. In this chapter we distinguish between investment grade and speculative grade firms. Our results show that both investment grade and speculative grade firms possess higher levels of leverage than non-rated firms. This suggests that our results are not driven by the speculative grade firms in our sample. However, we do find that speculative grade firms have about 9 percentage points higher leverage ratios than investment grade firms. Two-stage econometric analysis shows that our results hold even after controlling for the effect of credit quality. The impact on leverage is still higher for firms with a speculative grade. The results in chapter 5 show that non-investment grade firms have approximately 6-8 percentage points higher leverage than firms with an investment grade. In this chapter we also examine whether there is a non-linear relationship between level of credit rating and leverage, with higher levels of leverage observed for mid-rated relative to their higher and lower rated peers. Our results do not provide support for the existence of a non-linear relationship between credit rating level and leverage. In chapter 6 we argue that bond market access is potentially more important to firms during a contraction in bank loan supply when firms without access to bond markets might find themselves constrained in the amount of debt capital they can raise. The 2007-2009 financial crisis and the resulting contraction in the flow of bank credit to the UK corporate sector demonstrated that access to diversified sources of debt funding had never been more important. In this chapter the period we investigate is interesting as it exhibits significant variation in credit market conditions with this variation being greater than the periods examined in previous studies. The key finding of this chapter is that the leverage difference between firms with and without access is greater during periods of credit market tightening and smaller when credit conditions are loose. The results show that debt market segmentation did not matter when credit conditions were loose, such as the period 2004 to 2007 prior to the financial crisis, as banks were willingly providing loans to the UK corporate sector. However, in 2008 at the height of the financial crisis, firms that could not switch from bank to bond market debt found themselves most severely financially constrained. Consistent with Bank of England evidence, which reports that smaller firms have suffered disproportionately in terms of the cost and availability of bank credit during the financial crisis, we find that positive access effects on leverage are greatest when we compare firms with access against the smallest firms in our sample. The results in this chapter also suggest that the economic importance of possessing access to bond markets is greater in the UK than that seen in the US which is consistent with the notion that UK firms are over reliant on bank credit for their debt financing needs.

A version of Chapter 6 has been published in the following journal: Judge, A., and Korzhenitskaya, A., 2012. Credit market conditions and the impact of access to the public debt market on corporate leverage. International Review of Financial Analysis, 25 (C), pp. 28-63. The following two short articles related to the work in this thesis have been published in The Treasurer, which is a finance industry journal published by the Association of Corporate Treasurers. Judge, A., and Korzhenitskaya, A., 2013. Beating the Squeeze. The Treasurer, April, pp.32-23. Judge, A., and Korzhenitskaya, A., 2013. Banking on Bonds. The Treasurer, October, pp.28-29.