Hedging and the Terms of Debt

A new academic research paper by Campello, Lin, Ma and Zou takes a stab at documenting the impact of corporate hedging on the terms at which the company can borrow money in the syndicated loan market. (older version available here for free) For the last two decades, syndicated loans have been the largest source of funding for corporations, larger than the bond issuances. The study looks at hedging and loans at 1200 firms over the years 1996-2002. The authors advertise the paper as a look at one important channel through which hedging may add value to companies.

The findings are…
1. Increased hedging lowers the loan spread.
Companies with average usage of hedging derivatives are charged loan spreads that are 28% lower than non-hedgers. The impact is stronger for companies with higher probability of bankruptcy (lower Z-scores) and for companies with higher growth opportunities (higher market-to-book ratio).
2. Increased hedging lowers the probability that a loan will include a covenant restriction on investments.
An average hedger has 20% less probability of facing investment restrictions than a non-hedger. In addition, a one-standard deviation drop in Z-score increases the likelihood that the lender will impose a capital expenditure restriction on a non-hedger by 15.5%, compared to a statistically insignificant 5.2% for a hedger.
3. Increased hedging increases investment spending by 13% over the mean level.

Three comments.

First, while the paper’s results are surely important, the discussion of the impact on firm value is very confused. For example, an effort is made to decompose the portion of the loan spread that reflects an adjustment in the nominal rate in order to compensate for the expected loss of default, and the portion that equals the true economic rate of return. The authors label this latter variable the “true cost of debt”. But it is not a deadweight cost, so whether hedging reduces this true cost or not does not answer the question of whether hedging raises the value of the firm. Assuming a Modigliani-Miller world, hedging lowers the systematic risk of the firm and therefore its expected return on capital. The return on debt will fall, accordingly. But this leaves firm value unchanged. We can abandon the Modigliani-Miller assumption and recognize that hedging may somehow reduce deadweight costs and therefore does increase firm value. But still, this reduction in deadweight cost isn’t measured by the authors’ “true cost of debt” variable.

Second, the paper’s conclusion about the impact of hedging on investment is too certain. Here’s a counterexample that fits the findings but not the arguments in the paper. Consider the case of firms that need to make significant investments to stay strong in highly competitive industries. Presumably banks would not impose restrictions on capex but would require hedging given the nature of the competitive environment. What is then the causality between greater hedging intensity and more investment?

There is a large literature debating whether or not financial constraints impact corporate investments. For example, we posted about a recent paper in the Journal of Finance that claims there is no impact. If constraints in general do not impact investments, then hedging will not likely impact investments. Hedging is only supposed to loosen these constraints. While we lean in favor of a belief that financial constraints do matter for investments, and so hedging could very easily impact investments, any paper that purports to establish this empirically at least needs to make an earnest nod in the direction of the larger literature and uncertainty on the matter.

Third, another problem with the causality between the hedging and the price of the loans arises from the fact that the banks giving the loans are oftentimes the same banks offering the hedge. When two services are sold at the same time, one should be cautious about making much of the price quoted on one of the two services. If I buy a new car and get a great discount from the sticker price, you might be less impressed if you knew that I traded in my used car and can’t tell you the terms of the trade-in.

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