Bank Debt Reduction Announcements and Negative Signaling

Abstract

We examine 242 NYSE/AMEX and OTC common stock offerings that reduce bank debt and 254 that retire nonbank debt. We discover that bank debt reductions are associated with negative announcement period stock returns that are more than twice the magnitude of the negative returns found for nonbank debt reductions. The significant difference in returns indicate bank debt reductions transmits negative information beyond that previously cited in the stock offering literature. Regression tests show that the explanatory variable representing bank debt signaling models best explains stock returns.█ 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 ModelsEvent 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 stoc...

Issue Costs and Common Stock Offerings

“…The major use of the cash proceeds for these offerings are presumably for asset change purposes (whereas firms in our sample use the proceeds to reduce debt). Our two-day CAR magnitude is greater than the -2.34% CAR reported by Hull and Moellenberndt (1994) for the same two days. Like this study, they examine NYSE/ AMEX/OTC stock-for-debt transactions (n=496).…”

“…In addition, we provide empirical evidence concerning the importance of issue costs as evidenced by the insignificant CARs for the OTC and AMEX tests when the CARs are adjusted for cash flotation costs and underpricing. Our economically meaningful and statistically significant results suggest that the support for negative signaling/agency/tax effects (e.g., Fama, 1985;Myers and Majluf, 1984;Leland and Pyle, 1977;Ross, 1977;Jensen and Meckling, 1976;and Modigliani and Miller, 1963) given by prior research (e.g, Dierkens, 1991;Cornett and Travlos, 1989;Hull, 1994;Hull and Moellenberndt, 1994;Masulis and Korwar, 1986;and Masulis, 1983) may not individually or collectively be as important as generally believed.…”

“…Their analysis of primary offerings eliminates any "hidden" purpose (that is, insider sales) that may occur when a secondary offering is attached. As suggested by prior research (e.g., Masulis and Korwar, 1985;Hull and Moellenberndt, 1994;andHull andPinches, 1994/1995) combination offerings involve decreases in fractional share holdings of insiders. As posited by the signaling model of Leland and Pyle (1977), this would cause combination offerings to have more negative CARs than primary offerings (and thus have CARs which are less likely to be explained by issue costs).…”

“…For example, we repeat regression tests similar to those conducted by Hull and Moellenberndt (1994) but use adjusted CARs as the dependent variable. For brevity, we omit the details-but we can say that, like Hull and Moellenberndt, we find statistically significant support (albeit somewhat weakened) for signaling effects premised on changes in fractional holdings of insiders and actions by bankers.…”

“…The mean fall in stock value represents 61% of the mean fall in stock value. 1 Like others (e.g., Hull andFortin, 1993/1994;and Hull and Moellenberndt, 1994), we classify an observation as a combination offering when the primary component of the common stock offering is accompanied by a registered secondary component that is at least 10% of the combined primary and secondary components.…”