Board of Governors of the Federal Reserve System

May 03, 2024

Firms' financing choice between short-term and long-term debts: Are they substitutes?¹

Sam Hempel, Yi Li, and Sean Tibay

1. Introduction

When selecting debt to finance their operations and investments, companies face crucial decisions regarding the appropriate types of debt. Despite the classic Modigliani–Miller (1958) capital structure irrelevance result, real-world market frictions can significantly impact a firm's capital structure decisions.² This reality means that one debt type is not a perfect substitute for another, due to differences in important factors including maturity structures, funding purposes, rollover risks, and funding costs.

A prime example of this is the choice between commercial paper and corporate bonds. The primary distinction lies in their maturity structure. Commercial paper (CP), with an average maturity of about 30 days, is used for immediate needs such as operational expenses and inventory financing. In contrast, corporate bonds, with an average maturity of around 10 years, are suited for financing long-term projects like expansion and capital expenditure. This difference in maturity leads to differences in relative funding cost – CP tends to be cheaper and more flexible for issuers – and in rollover risk: CP faces high rollover risk due to its short-term nature, while corporate bonds are relatively stable.³ This is particularly notable given that institutional investors like prime money market funds (MMFs), known for their susceptibility to runs and risk aversion, are important financiers of commercial paper.

Academic literature discusses the choice between these two instruments in terms of maturity structure and associated rollover risks. The seminal work by Kahl, Shivdasani, and Wang (2015) suggests that firms initially use commercial paper as a flexible bridge financing tool for starting investments and later transition to bond financing if the investment is successful to reduce rollover risks. This perspective primarily views the shift from commercial paper to corporate bonds as a unidirectional move aligned with a firm's investment stage.

However, recent trends indicate that firms might alternate between these debt types more frequently than theoretical models predict, for reasons beyond maturity structure and rollover risks. In particular, factors like relative funding costs and interest rate volatility are likely to play a significant role in these decisions. For instance, Bloomberg and IFR reported in the summer of 2022 that firms appeared to adjust their debt choices based on the shape of yield curves.⁴ In addition, during periods of volatility in long-term interest rates, firms might favor commercial paper to avoid locking in higher rates for extended periods, hoping to ride out the interest rate fluctuations.

Despite extensive discussion in both academic and industry circles about choosing between commercial paper and corporate bonds, the extent of substitution between these instruments and the drivers behind such decisions remain unclear. Addressing these questions requires a detailed examination of micro-level data, specifically the issuance records of both commercial paper and corporate bonds for individual firms. This note is the first to amalgamate and analyze such micro-level data, offering new insights into these financial instruments' usage and interchangeability.

In this note, we present evidence that nonfinancial firms substitute between CP and corporate bonds. Unlike past literature – but consistent with anecdotal evidence from recent media reports – we find that this effect is bi-directional, with firms substituting both from CP to bonds and vice versa. In fact, we find a greater degree of substitutability when firms shift from bonds to CP than when they move in the other direction. Furthermore, our evidence for substitutability is strongest among the highest rated firms. These results suggest that nonfinancial firms may not necessarily follow a maturity-matching principle in their financing decisions, which could result in greater exposures to rollover and interest rate risks and affect financial stability.

2. Data & Methodology

To study substitution between CP and corporate bonds, we combine data from a number of sources. For CP, we draw on daily transaction-level data from the DTCC, which identify the issuer, face value, and yield of each instance of primary-market CP issuance.⁵ We combine these transaction-level data with CP issuer credit ratings from Moody's and Standard & Poor's.⁶ For corporate bond primary issuance, we use Mergent FISD data. By hand-matching CP issuer names and bond issuer names, we connect CP issuance and bond issuance at the issuer-date level.⁷ These data are the primary inputs for our analysis, but we also use data from Compustat (quarterly firm-level data), SEC Form N-MFP (monthly money market fund holdings of CP), FRED (market-wide indicators), and ICAP (swaption-implied rate volatility).

Using these data sources, we construct a quarterly sample of 410 nonfinancial firms from Q1 2012 through Q4 2022.⁸ To examine the extent of potential CP-bond substitution, we study the relationship between net CP issuance and net bond issuance, using variations of the following regression specification, where firms are indexed by i and quarters are indexed by t. ⁹

$$$$ Net\ CP\ issuance_{i,t} = \alpha + \beta Net\ bond\ issuance_{i,t} + \sum_j \gamma_j Controls_{i,t} $$$$

In this setting, if $$ \beta < 0 $$, then that would suggest that firms are using CP and corporate bonds as substitutes: an increase (decrease) in net bond issuance is correlated with a decrease (increase) in net CP issuance. Conversely, if $$ \beta > 0 $$, then that would suggest that firms are using CP and corporate bonds as complements: an increase in net bond issuance is correlated with an increase in net CP issuance. To isolate the effect of substitution between CP and bonds, we include a number of control variables, some of which are measured at the firm-quarter level (Table 3) and others that are market-wide (Table 4).

3. Results

Table 1 presents our baseline results. In the first column, we show that in the full sample, there is a significant substitution effect between firms' issuance of CP and corporate bonds, as indicated by the negative estimated $$ \beta $$. Specifically, our results show that a $1.00 increase in a firm's net corporate bond issuance is correlated with a $0.053 decrease in that firm's net CP issuance over the same quarter. Furthermore, when repeating our tests using the subsamples defined by issuers' credit ratings, we find that this substitution effect is strongest for highest-rated issuers (i.e., issuers with an A1/P1 short-term rating), suggesting that firms with the best credit ratings tend to be most flexible in substituting between short-term and long-term debt.¹⁰ Additionally, because our specification includes both issuer fixed effects and time fixed effects, our results control for any potential influences from time-invariant firm characteristics and time-varying market-wide factors.¹¹

Table 1: Baseline results on CP and corporate bond substitution

Table 2 provides additional insight into the CP-bond substitution effect by differentiating between net increases and net decreases in bond issuance. Specifically, we use two independent variables: $$ Net\ bond\ issuance_{i,t}\mid\ > 0 $$, defined as $$ max\{0, Net\ bond\ issuance_{i,t}\} $$, and $$ Net\ bond\ issuance_{i,t}\mid\ < 0 $$, defined as $$ min\{0, Net\ bond\ issuance_{i,t}\} $$. Essentially, this decomposition allows us to examine any asymmetry in the direction of substitution between CP and bonds. The point estimates in Table 2 suggest that the substitution effect is stronger when firms are reducing their bonds outstanding and increasing their CP, though the difference between the two directional coefficients is not statistically significant. Specifically, in Column (1), a $1.00 increase in net bond issuance is correlated with a $0.047 decrease in net CP issuance. However, a $1.00 decrease in net bond issuance is correlated with a $0.079 increase in net CP issuance. Consistent with the results in Table 1, we find that in both directions the substitution effect is strongest for the highest rated firms.¹²

Table 2: Directional results on CP and corporate bond substitution

One potential concern with our results is that the choice between commercial paper and corporate bonds is entirely driven by some observable, time-varying firm characteristics. To address this concern, we construct lagged firm-level variables to capture factors related to leverage level (debt ratio), funding uses (short-term investment ratio, R&D intensity), and funding sources (share of a firm's CP held by money market funds). Table 3 presents the regression results with the inclusion of these firm-level control variables, in addition to the issuer fixed effects that capture any unique features of an issuer that do not vary over time.

Column (2) of Table 3 shows that the substitution effects between CP and corporate bonds are robust to the inclusion of firm-level controls. The substitution level is quantitatively similar to the baseline results: a $1.00 increase (decrease) in net bond issuance is correlated with a $0.060 decrease (increase) in net CP issuance. Column (1) presents the stand-alone effects of firm-level controls on CP issuance, showing that CP issuance is negatively correlated with lagged debt ratio and positively correlated with lagged R&D intensity.¹³

Table 3: Firm-level control variables

Additionally, column (3) includes interaction terms between corporate bond issuance and firm-level control variables, which allow us to analyze whether certain firm characteristics amplify or diminish the substitution between commercial paper and corporate bonds. For example, column (3) shows that the substitution effect is amplified for firms that have a higher fraction of their CP owned by money market funds (MMFs): a one-standard-deviation increase in a firm's MMF ownership is correlated with its CP-bond substitution effect increasing from 0.049 to 0.090. This result is consistent with the rating effect shown in Table 1: CP owned by MMFs tends to be highly rated.

Our regression analyses thus far include time fixed effects, which capture aggregate effects in a given quarter. To explore whether and how market-wide trends drive the CP-bond substitution effect, we remove these fixed effects and instead use multiple indicators of market conditions. Specifically, we include the 10-year minus 3-month Treasury yield curve slope (to capture the relative costs of short-term vs. long-term debt), aggregate corporate bond spreads and CP spreads (to capture the overall state of the respective funding markets), swaption-implied interest volatility (to capture monetary policy uncertainty), and the VIX (to capture broader volatility in financial markets).¹⁴ Table 4 shows the results of including these indicators and their interactions with net bond issuance in place of time fixed effects.

Table 4: Market-wide control variables

Table 4 shows that the primary finding on the substitution effect between commercial paper and corporate bonds is quantitatively similar to baseline results when market-wide indicators are included in the regression. Specifically, we find that a $1.00 increase (decrease) in net bond issuance is correlated with a $0.056 decrease (increase) in net CP issuance.

Looking at the regression coefficients on market-wide indicators, we find some evidence that is consistent with anecdotal reporting; namely, that a steeper yield curve and higher interest rate volatility are both associated with more CP issuance. Interestingly, we also find that net CP issuance is positively correlated with market-wide CP spreads.¹⁵ In the interaction terms, we see that the substitution effect is amplified when corporate bond spreads are higher. As a whole, these results raise some potential financial stability concerns: if relatively cheaper funding entices firms to shorten their debt maturity and switch from corporate bonds to CP, then that leaves them more exposed to interest rate and rollover risks. Our analysis here is not sufficient to probe these questions in depth but points to promising directions for future research.

4. Conclusion

In this note, we study firms' choices between the issuance of short-term debt (commercial paper) and that of long-term debt (corporate bonds). Using confidential micro-data, we provide evidence that firms substitute between these two markets in a bi-directional manner that is novel to the existing literature, and that firms with higher short-term ratings substitute CP and bonds to a greater extent. We also find suggestive evidence that the substitution between short-term and long-term debt could be driven by factors beyond maturity matching and rollover risks, including the yield curve (which contributes to firms' relative funding costs at different maturities), firms' considerations of relative funding costs, and market uncertainty. These findings shed new light on firms' financing decisions, which may affect their exposures to interest rate and rollover risks and thus have implications for broader financial stability.

References

Kahl, Matthias, Anil Shivdasani, and Yihui Wang (2015). "Short-Term Debt as Bridge Financing: Evidence from the Commercial Paper Market," Journal of Finance 70 (1), 211-255.

Modigliani, Franco, and Merton H. Miller (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review 48 (3), 261-297.