Tutorial 1: How did COVID-19 affect firms' access to financing?

Question 1

How did COVID-19 affect firms’ supply of capital?

Answer 1

• INCREASED ISSUANCE OF BBB-RATED BONDS –> concerns of institutional investors e.g. insurance companies offset by ‘reaching-for-yield’ behaviour by bond investors, where they may be willing to take on slightly higher risk in search of higher returns in low IR environment –> increased demand for bonds driven by other investors e.g. hedge funds & mutual funds, who were more willing to invest in BBB-rated securities during volatile market conditions of pandemic –> slack regulatory constraints –> extra yield offered by these bonds compensating for higher risk associated w lower credit ratings, making bonds more attractive to investors seeking higher returns in low-interest-rate environment.

Question 2

How did COVID-19 affect bond issuances?

Answer 2

• Firms issued bonds w LONGER MATURITIES–> high econ. uncertainty & mkt volatility meant firms preferred to postpone rollover risk into future, providing them w greater financial stability & flexibility –> ensures access to capital over extended period –> might lead to substantial underinvestment incentives during volatile times.
• Firms issued bonds w HIGHER SPREADS (diff. in yield between risk-free treasury & corporate bonds) —> investors demanded higher return to compensate for increased perceived risk in time of econ. uncertainty –> firms issue bonds on more attractive terms to attract investors & successfully raise capital.

Question 3

Why did bond issuances increase during COVID-19?

Answer 3

FED PROGRAMS RESTORED TRUST IN BOND MKT –> supported bond mkts by providing liquidity & confidence to investors, encouraging firms to issue bonds & increased investor participation –> improved bond market access for wider range of firms i.e. lower-rated, smaller, & less experienced entities.

Question 4

How did equity issuances change during COVID-19?

Answer 4

DECREASED –> due to increased econ. uncertainty & mkt volatility –> firms less likely to issue info-sensitive equity securities so as not to deter risk-averse investors –> flight-to-quality hypothesis also explains that risk-averse investors prefer relatively safer assets e.g. bonds in uncertain times –> hence reduction in IPOs –> more capital raised in debt (safer, fixed income securities) than equities.

Question 5

What are firm-specific characteristics determining bond spreads that influence firms’ access to capital?

Answer 5

1) TANGIBILITY (possessing more tangible assets e.g. property, equipment, inventory can serve as collateral) –> higher tangibility, lower spread (collateral effect): bond investors may perceive lower risk in case of default as tangible assets used as collateral, increasing likelihood of repayment & reducing credit risk hence lower additional yields demanded by investors or holding corporate bonds over risk-free gov. bonds –> higher tangibility, higher spread: firm’s tangible assets less flexible & able to adapt to changing mkt conditions during econ. uncertainty i.e. difficulties in quickly adjusting business strategies/reallocating resources/responding to unexpected disruptions –> investors may perceive firms as more risky hence higher bond spreads to compensate investors.

2) DIVIDEND PAYMENTS –> value firms (dividend-paying): more adversely affected by pandemic due to need to maintain dividend payments whilst experiencing potential revenue declines, operational challenges & liquidity constraints so investors may perceive higher risk due to difficulties in firms sustaining dividend payouts, leading to higher spreads on bonds as compensation –> growth firms (non-dividend paying): less affected by pandemic due to ability to prioritise reinvesting profits into innovation & expansion to drive future business growth rather than regular dividend distributions so bond investors may perceive lower risk associated w ease of adapting capital allocation strategies hence lower credit spreads on bonds as compensation.

3) BOND ISSUING EXPERIENCE –>
more experienced bond issuers: lower perceived risk by investors due to higher trust & confidence in ability of firms to meet bond obligations hence pay lower credit spread as compensation –> firms can access lower cost of borrowing & on more favourable terms for bond issuances.