The Composition and Priority of Corporate Debt: Evidence from Fallen Angels* Joshua D. Rauh University of Chicago Graduate School of Business and NBER Amir Sufi University of Chicago Graduate School of Business January 2008 *We thank Doug Diamond, Anil Kashyap, Raghu Rajan, Michael Roberts, Luigi Zingales, and seminar participants at Chicago GSB, Rice University, Tilburg University, and Maastricht University for comments. We gratefully acknowledge financial support from the Center for Research in Security Prices and the IBM Corporation. Thanks to Adam Friedlan for excellent research assistance. Rauh: (773) 834 1710, [email protected]; Sufi: (773) 702 6148, [email protected] Composition and Priority of Corporate Debt: Evidence from Fallen Angels Abstract We examine the composition and priority structure of corporate debt for firms downgraded from investment grade to speculative grade. Our findings demonstrate the importance of recognizing debt heterogeneity in capital structure studies, and they support theoretical models in which debt structure is set to encourage bank monitoring. Firms experience dramatic changes in debt structure after a downgrade, despite maintaining similar leverage ratios. Post-downgrade, there is a sharp reduction in both bank and non-bank discretionary sources of debt finance, such as revolving credit facilities, commercial paper, and medium-term notes. Firms “spread” the priority structure after credit quality deterioration: While most debt is at the senior unsecured priority level before the downgrade, firms sharply increase their use of both secured bank debt and subordinated private placements and convertibles after the downgrade. Post-downgrade, the relative monitoring intensity of bank versus non-bank debt sharply increases.2Corporate debt is characterized by heterogeneity. Indeed, most corporations obtain debt from both bank and non-bank sources, and structure their debt claims into priority classes with a variety of conditions and restrictions. While a large body of theoretical research explores the optimal composition and priority of corporate debt for different types of firms, the grand majority of empirical capital structure research continues to treat corporate debt as uniform. As a result, there are few empirical studies that examine why firms simultaneously use different types, sources, and priorities of corporate debt. This study attempts to answer two questions regarding debt structure: First, how do firms structure their debt? Second, what existing theory best explains why firms simultaneously use different types, sources, and priorities of debt? To answer these questions, we examine the debt composition and priority of “fallen angels,” which we define as firms that have their debt downgraded from investment grade to speculative grade by Moody’s Investors Services. Our focus on variation in credit quality follows directly from extant theoretical research in which credit quality is the primary source of variation driving a firm’s optimal debt structure (e.g., Diamond (1991) and Bolton and Freixas (2000)). By investigating fallen angels, we are able to isolate specific variation in credit quality that is explained in detail in the credit rating agencies’ reports. This information allows us to assess the precise relation between credit quality and debt structure. Our analysis employs a novel data set that records the source, type, and priority of every balance-sheet debt instrument for fallen angels from two years before to two years after the downgrade. These data are collected directly from financial footnotes in firms’ annual 10-K SEC filings and supplemented with information on pricing and covenants from three origination-based datasets: Reuters LPC’s Dealscan, Mergent’s Fixed Income Securities Database, and Thomson’s SDC Platinum. To our knowledge, this data set is one of the most comprehensive sources of information on the debt structure of a sample of public firms: It contains the detailed composition of the stock of corporate debt on the balance sheet, which goes far beyond what is available from origination-based datasets alone. We begin our analysis by showing the importance of recognizing debt heterogeneity in capital structure studies. We show that 95% of firms in our sample simultaneously use bank and non-bank debt,3and bank debt accounts for a substantial fraction of firm capital structure. In addition, we show that a unique focus on leverage ratios misses important variation in capital structure decisions. For example, more than half of the firm-year observations in our sample maintain a relatively constant debt level with respect to the previous year. However, among these firm-year observations with constant debt levels, more than 30% experience major adjustments in the composition of their debt. This variation in debt structure would be missed in studies that focus solely on leverage ratios. We then empirically assess the relationship between credit quality and debt structure. We find that downgraded firms experience a sharp reduction in the availability of “discretionary” debt financing, such as commercial paper, medium-term notes, and bank revolving credit facilities.1 For example, using firm-fixed effects regressions, we show that bank revolvers as a fraction of total assets drop by 0.045, which is more than a 30% effect evaluated at the mean. The reduction in discretionary public debt (commercial paper and medium-term notes) is even more dramatic: post-downgrade, firms reduce discretionary public debt by almost 70% when evaluated at the mean. These findings suggest that firms face reduced availability of both bank and non-bank discretionary sources of debt financing. Our evidence on the use of bank versus non-bank debt after the downgrade is mixed. Total bank debt capacity—the sum of term bank debt and the used and unused portion of revolvers—declines after the downgrade. However, the decline in total bank debt capacity is driven by the large decrease in unused revolvers. In contrast, bank term debt and the used revolvers slightly increase, especially in the year of the downgrade. In terms of non-bank debt, we find strong evidence that firms begin issuing more Rule 144A private placements and convertible debt. For example, as a fraction of assets, private placements and convertibles increase by almost 0.04 after the downgrade, which