Market Timing, Interest Rate Illusions and Mismatched Debt: A Behavioral Perspective
The argument that we should match the cash flow on debt to the cash flow on assets is based on the premise that managers are not very good at timing markets and/or assessing what types of debt are cheap or expensive. That premise may not be wrong b that does not stop managers from trying to use what they perceive to be "cheap" debt, even if it results in mismatching debt to assets.
a. Playing the term structure: In the last chapter, we presented evidence that managers try to time markets with equity and bond issues, issuing more equity when they fell that their stock is over priced and less equity when they feel it is over priced. There is also evidencd that the managers are more likely to use short term debt, when the yield curve is "too steep" and more long term debt, when it is "too flat".
b. The convertible option: The use of convertible securities - convertible bonds and preferred stock - increases when managers perceive their stock to be over priced and decreases when it is considered under priced.
c. The Interest rate illusion: When comparing different types of borrowing, some managers find themselves comparing the interest rates on the debt issues, with the view that lower interest rates represent cheaper financing. It is this rationale that allows some managers to think fo short term debt is cheaper than long term debt and that convertible debt is less expensive than straight debt. In emerging markets, borrowing in the local currency (with higher expected inflation) looks more expensive than borrowing in a foreign currency.
As a consequence of these factors, the debt used by a firm can be at variance with the assets funded with this debt. While it may be impractical and perhaps even unwise to ask managers to stop trying to pick the cheapest debt, there are three things we can do to minimize potential damage:
- We can impose constraints that prevent the mismatch from becoming too severe. For instance, a firm whose asset are 20% short term and 80% long term may specify that short term debt cannot exceed 40% of overall debt.
- We can use the derivatives and swaps markets to hedge some of the mismatch risk, at least at the aggregate level. Thus, a firm that chooses to use Japanese yen to fund Euro assets, because managers believe that Yen debt is cheaper than Euro debt, can use currency futures to hedge some of its Yen/Euro risk exposure.
macrodur.xls: This spreadsheet allows you to estimate the sensitivity of firm value and operating income to changes in macroeconomic variables.
There is a data set online that summarizes the results of regressing firm value against macroeconomic variables, by sector, for U.S. companies.