Trevor Chamberlain, Ph.D., Finance and Business Economics, McMaster University, 1280 Main Street West, DSB/304, Hamilton, ON L8S 4M4, Canada
Liquidity, Investment and Risky Debt: Some Evidence
Utilizing bond data for U.S. non-financial corporations, this study finds a relationship between liquid asset holdings and default premia. The paper argues that this result is explained by endogenous adjustments in liquid asset holdings by firms concerned with the possibility of a liquidity shortage, which, in the presence of external financing constraints, may trigger default and the costs of financial distress. As a result of this endogenous adjustment in liquidity, riskier firms have not only higher default premia, but also higher equilibrium holdings of liquid assets. Thus, the endogeneity of liquidity may be central to the interaction between default risk and the condition of the firm’s balance sheet. Simple regressions that treat liquidity as an exogenous parameter may therefore yield unreliable results.
In the model utilized in this study, the observed positive relationship arises when future firm cash flows cannot be fully pledged as collateral for borrowing and the benefits of firm investment can only be realized if the firm does not default on its debt. At the same time, exogenous changes in the firm’s liquidity that are unrelated to default risk factors are expected to be negatively related to default premia. The prior expectation that firms with high liquidity should be safer explains the direct effect of liquidity on default premia, but does not capture the indirect effect arising from the endogeneity of liquidity, which appears to dominate in practice.
Most previous studies have focused primarily on leverage and volatility as determinants of default premia, and ignore the potential effect of liquidity (Merton, 1973). Others assume that default is triggered by a shortage of cash, but do not allow for an endogenous determination of liquidity. The results obtained in the present study suggest that firm characteristics that determine default premia, such as leverage, volatility, profitability and financing constraints, may also affect the firm’s liquidity position, which, in turn, affects default spreads. Incorporating liquidity and its determinants into models of default premia is a question that requires further research. The current results also suggest that common empirical specifications in studies of default premia, which use default risk variables suggested by extant debt pricing models, may be important variables that determine a firm’s liquidity holdings and default premia.
The results of this study also suggest a reconsideration of the role of balance sheet liquidity in empirical default-prediction models. Altman’s (1968) z-score model and those like it typically control for balance sheet liquidity. The effect of such variables appears to depend upon the prediction horizon. While the liquidity holdings of firms with limited access to external financing may be considered fixed for the short-term, for longer horizons, the endogeneity of liquid assets becoming a dominating factor, which cannot be overlooked in predicting the likelihood of default.
References
Altman, Edward I. “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy”. Journal of Finance 23 (1968), pp. 589-609.
Merton, Robert C. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates”. Journal of Finance 29 (1974), pp. 449-470.