The Maturity of Debt Issues and Predictable Variation in Bond Returns

Malcolm  Baker; Robin  Greenwood; Jeffrey  Wurgler

Article | Journal of Financial Economics | November 2003

The Maturity of Debt Issues and Predictable Variation in Bond Returns

by Malcolm Baker, Robin Greenwood and Jeffrey Wurgler

Abstract

The maturity of new debt issues predicts excess bond returns. When the share of long-term debt issues in total debt issues is high, future excess bond returns are low. This predictive power comes in two parts. First, inflation, the real short-term rate, and the term spread predict excess bond returns. Second, these same variables explain the long-term share, and together account for much of its own ability to predict excess bond returns. The results are consistent with survey evidence that firms use debt market conditions in an effort to determine the lowest-cost maturity at which to borrow.

Keywords: Borrowing and Debt; Bonds; Investment Return; Financial Markets; Forecasting and Prediction;

Format: Print

31 pages

Find at Harvard Read Now

Citation:

Baker, Malcolm, Robin Greenwood, and Jeffrey Wurgler. "The Maturity of Debt Issues and Predictable Variation in Bond Returns." Journal of Financial Economics 70, no. 2 (November 2003): 261–291.

Reflexivity is the idea that investors' biased beliefs affect market outcomes, and that market outcomes in turn affect investors' beliefs. We develop a behavioral model of the credit cycle featuring such a two-way feedback loop. In our model, investors form beliefs about firms' creditworthiness, in part by extrapolating past default rates. Investor beliefs influence firms' actual creditworthiness because firms that can refinance maturing debt on favorable terms are less likely to default in the short run—even if fundamentals do not justify investors' generosity. Our model is able to match many features of credit booms and busts, including the imperfect synchronization of credit cycles with the real economy, the negative relationship between past credit growth and the future return on risky bonds, and "calm before the storm" periods in which firm fundamentals have deteriorated but the credit market has not yet turned.

On the afternoon of Monday October 13, 2008, Hank Paulson Jr., the Secretary of the Treasury of the United States, walked into the large conference room across the hall from his office in the Treasury Department. Joining him were Federal Reserve Chairman Ben Bernanke, President of the Federal Reserve Bank of New York Timothy Geithner, Chair of the Federal Deposit Insurance Corporate Sheila Bair, and the Chief Executive Officers of nine of the largest banks in the United States. This distinguished group had been brought together by the most serious financial crisis since the Great Depression of the 1930s. Financial panic was pushing the U.S. and European financial systems to the brink of failure. Paulson hoped his meeting with the bank CEOs would be a turning point. U.S. financial markets were closed for Columbus Day, and Paulson was planning to announce the latest government actions to stabilize the financial system before markets reopened on Tuesday.

In February and March 2009, the U.S. economy was in the midst of a terrifying financial and economic crisis. Between the beginning of 2008 and early 2009, four of the 25 largest U.S. financial institutions had failed, and nine of these 25 institutions had taken extraordinary steps to avoid failure—either receiving one-off government support, merging with another firm, or submitting to heightened regulation to qualify for future government support. Led by Treasury Secretary Timothy Geithner, the government had to quickly devise policies to stabilize the financial system and the economy. The case explores the details of policies, and the decision making process that led to them, that Geithner and his team devised under immense time pressure to stabilize the system. The case features an extended discussion of Geithner’s innovative “stress test,” which would reveal the longer-term health of the country’s largest banks.

Faculty & Research

The Maturity of Debt Issues and Predictable Variation in Bond Returns

Abstract

Citation:

About the Authors

More from these Authors