Debt reduction help

Bankers are parties to information about a firm's financial condition through their special relationship as lenders. This premise is the basis for the predictions of bank debt signaling models, which posit that bank debt issuance announcements convey positive news about a firm. Empirical research on debt offering announcements that raise cash for multi-corporate purposes supports this claim. The research documents statistically significant positive stock price reactions to bank debt announcements and negative reactions to nonbank debt announcements.

If bank debt issuance announcements signal more favorable news than nonbank debt announcements, it follows that bank debt reduction announcements should signal more negative news than nonbank debt reduction announcements. Market participants will view bank debt reduction announcements as the result of decisions made by bankers acting upon unfavorable inside information.

Our study extends prior research on equity offerings that reduce debt. We analyze 242 stock offering announcements that reduce bank debt, and 254 announcements that retire nonbank debt. Consistent with the predictions of bank debt signaling models, returns for bank debt reductions are more negative than returns for nonbank debt reductions, and the differences in returns are statistically significant.

I. Competing Capital Structure Models

Event study research finds a significant negative stock valuation effect for equity-for-debt transactions such as exchange offers, private swaps, and stock offerings that raise cash to reduce debt. These findings are consistent with capital structure models that predict negative tax, agency, and signaling effects.

Tax models, rooted in Modigliani and Miller (1963), hypothesize negative stock price behavior from lost tax shields when firms undergo stock-for-debt transactions. Agency models that deal with risk shifting, such as the intrasecurity wealth transfer model of Galai and Masulis (1976), also hypothesize negative stock price behavior. The cash flow payments to debtholders become less risky, while payments to stockholders become more risky. This causes wealth transfers from stockholders to debtholders.

Asymmetrical information models (e.g., Leland and Pyle (1977) and Ross (1977)) predict that stock-for-debt transactions signal negative news. Leland and Pyle connect negative signaling to decreases in the percentage of inside ownership caused when insiders do not participate in the stock offering.(1) Ross links the negative signaling to the reduction in debt. Decreases in debt convey negative information about a firm's ability to service current debt levels.

Signaling models that stress the role of bankers as insiders (e.g., Fama (1985), Kane and Malkiel (1965), and Bernanke (1983)) argue that firms announcing bank debt agreements convey positive news. That is, bankers would not approve or extend a loan if inside information acquired in the lending process were negative. It follows that the market will suspect that bank debt reductions are prompted by negative inside information. Thus, announcements of bank debt reduction should result in greater negative news than announcements of nonbank debt reduction. Nonbank loans (including private nonbank debt) are not normally subject to periodic review and termination. Therefore they should be free from negative signaling effects associated with insiders who are lenders.

II. Prior Empirical Findings

In this section, we review the empirical findings for stock offering and bank loan announcements. While prior research has found that bank loan announcements have different announcement period returns than nonbank debt announcements, studies of stock-for-debt transactions have not examined if bank debt reductions cause different announcement period returns than nonbank debt reductions.

A. Stock Offering Findings

Stock offerings can be classified into two general categories: "cash" and "noncash." The cash category involves stock issues that raise cash for debt reduction and other corporate purposes. These other purposes include capital expenditures, working capital increases, and general corporate requirements. The noncash category involves equity offerings where the new stock is traded for outstanding senior securities.

Cash offering studies (e.g, Asquith and Mullins (1986), Masulis and Korwar (1986), and Hull and Fortin (1993/1994)) find negative announcement period stock returns averaging over -3.0%. In general, cash offering studies indicate that the intended use of the cash proceeds has no obvious impact on returns.(2) For example, Masulis and Korwar (1986) report a two-day return of -3.84% when the proceeds are used for debt reduction (n = 55); -3.65% when used for capital expenditures (n = 63); and -2.52% when used for mixed purposes (n = 55).

Studies of noncash offerings include exchange offers (e.g., Masulis (1980, 1983) and Pinegar and Lease (1986)) and private swaps (e.g., Finnerty (1985), Peavy and Scott (1985), and Rogers and Owers (1985)). More recent work (e.g., Copeland and Lee (1991) and Cornett and Travlos (1989)) is on both exchange offers and swaps. The mean announcement period stock returns for noncash transactions range from -9.91%, as shown by Masulis (1983) for exchange offers of common stock for nonconvertible debt (n = 9), to -0.83%, as found by Peavy and Scott (1985) for swaps of common stock for debt (n = 72).

B. Bank Debt Findings

Research shows that banks play a unique role as transmitters of information in the capital markets. For example, Mikkelson and Partch (1986) find a statistically significant 0.89% mean announcement period stock return upon disclosure of bank loan agreements (n = 124), compared to a -0.57% return for private placements of debt (n = 57). James (1987) reports a significant 1.92% return for bank loan agreements (n = 80), in contrast to returns of -0.11% for public straight debt offerings (n = 90) and -0.91% for private placements (n = 37). When the announced purpose is to repay bank loans, the stock return is -1.63% for public debt offerings (n = 12) and -2.07% for private placements (n = 18).

Lummer and McConnell (1989) discover that the positive return seen in the case of bank loan announcements is not explained by actions on new bank loans or outstanding bank loans that are unfavorably structured, but by bank loans that receive favorable or mixed revision. They find positive returns of 0.87% for favorable revisions (n = 259) and 3.98% for mixed revisions (n = 76). For mixed revisions, the return is 4.82% when there is prior negative news (n = 50) concerning the loan (published in The Wall Street Journal) for the year prior to the revision announcement. The return is 2.35% when there is no prior negative news (n = 26).

The results of these studies suggest that stock issues that reduce bank debt obligations should experience more negative returns than stock issues that retire nonbank debt. This should be true especially if there is either non-negative news or no news about the firm's outstanding bank debt prior to the announcement.

III. Data and Methodology

The first part of this section describes our stock offering sample. The sample spans nearly two decades and is much larger than samples previously examined by similar studies. Next, we discuss the methodology for calculating announcement period returns and detail the primary tests that are performed.

A. Data

The primary sources of common stock offering announcements for the study are the Investment Dealers' Digest and The Wall Street Journal. Besides these two sources, the sources for the descriptive data are Compustat Annual Files, Moody's Industrial Manual, and the CRSP NYSE/AMEX and CRSP OTC daily prices and returns files. The data cover the years between 1970 and 1988.

The sample consists of 496 stock offerings that meet five criteria:

1. Each must be a common stock offering in which the stated purpose is to reduce some form of debt that is not convertible into equity.

2. Each must indicate whether the debt being retired is bank debt or nonbank debt.

3. Each must not be identified as a utility.

4. Each must be listed on the CRSP NYSE/AMEX return file or the CRSP OTC return file, and have sufficient trading data to calculate an announcement period cumulative abnormal return.

5. The percentage change in outstanding common stock must lie between 0.5% and 100%.

The 496 observations include 242 firms that retire bank debt and 254 that reduce nonbank debt. The sample also includes 117 that are listed on the CRSP OTC return file and 379 that are listed on the CRSP NYSE/AMEX return file. Of the 496 observations, there are 67 combination offerings (primary component plus registered secondary offering), and 429 primary offerings that are not accompanied by a secondary offering. An observation is classified as a combination offering if the primary portion of the offering is accompanied by a secondary offering that is at least 10% of the total offering.