Effect of rollover risk on default risk: Evidence from bank financing

Abstract

We study the effect of rollover risk on the risk of default using a comprehensive database of U.S. industrial firms during 1986-2013. Dependence on bank financing is the key driver of the impact of rollover risk on default risk. Default risk and rollover risk present a significant positive relation in firms dependent on bank financing. In contrast, rollover risk is uncorrelated with default probability in the case of firms that do not rely on bank financing. Our measure of rollover risk is the amount of long-term debt maturing in one year, weighted by total assets. In the case of a firm that depends on bank financing, an increase of one standard deviation in this measure leads to a significant increase of 3.2% in its default probability within one year. Other drivers affecting the interaction between rollover risk and default risk are whether a firm suffers from declining profitability and has poor credit. Additionally, rollover risk's impact on default probability is stronger during periods when credit market conditions are tighter.

Rollover risk and managerial cost adjustment decisions

“…Specifically, Wang et al . () find rollover risk is positively related to default risk for firms dependent on bank financing. Gopalan et al .…”

“…Empirical papers corroborate theoretical studies by documenting the effects of rollover risk on default risk (Wang et al ., ), credit quality (Gopalan et al ., ), and long‐term bond spreads (Gopalan et al ., ; Valenzuela, ). Specifically, Wang et al .…”

“…As discussed in Section 2, the detrimental effects of rollover risk include increases in default risk (He and Xiong, ,b; Wang et al ., ) and yield spreads on long‐term bonds (Gopalan et al ., ; Valenzuela, ), as well as decreases in credit quality (Gopalan et al ., ) and corporate investments (Duchin et al ., ; Almeida et al ., ). In addition, when refinancing, firms face the risk that changes in market conditions or capital market frictions could lead to much higher interest rates (Froot et al ., ) or inefficient liquidation of the firm (e.g., Diamond, , ; Sharpe, ).…”

“…Moreover, He and Xiong (,b) find that the adverse effects from refinancing risk are stronger when firm fundamentals deteriorate because firms with weak fundamentals are closer to default boundary, making it more difficult to refinance maturing debt. Finally, empirical evidence supports the above argument (Gopalan et al ., ; Valenzuela, ; Wang et al ., ). Due to these detrimental effects of rollover risk, we hypothesise that given rollover risk, managers prioritise the use of resources to mitigate rollover risk rather than maintain excess resources which exhibit cost stickiness.…”

“…Both actions should allow the firms to renew debt and obtain better terms in new debt contracts. Following prior literature (Almeida et al ., ; Gopalan et al ., ; Wang et al ., ), we measure rollover risk by the current due portion of long‐term debt. The initiation of long‐term debt results from past financing choices so that the maturing portion of long‐term debt is exogenous to current managerial cost decisions.…”