March 24, 2009

Corporate Managers Can’t Predict Future Interest Rates When Assuming Debt

Research by Dr. Steven C. Mann, Dr. Vassil Mihov, and Dr. Mauricio Rodriguez

In contrast to earlier research, a new study reveals that corporate managers are unable to time debt issues to their firms' financial advantage. This may present a serious reality check for some managers.

The study, incorporating greater detail than earlier work, shows that, in most instances, corporate officers simply do not possess the financial prognostication skills that would allow them to lower the costs of obtaining capital via timing future movements in interest rates.

"Some past research showed that managers were able to anticipate when interest rates were going to change. However, we found that managers, overall, are not successful in anticipating when interest rates are going to go up or down," says Dr. Christopher B. Barry, finance professor at Texas Christian University in Fort Worth.

While other studies also have contradicted this supposed ability, the research indicating successful timing and that showing contrasting findings both used relatively small sample sizes and examined only annual data.

"The earlier evidence for successful timing looked at a very narrow set of data including only 47 debt issues, while we had more than 55,000, and (they) utilized annual data, while we gathered vastly more detail by using monthly figures," says Dr. Barry.

"Interest Rate Changes and the Timing of Debt Issues," by Dr. Barry, Dr. Steven C. Mann, Dr. Vassil Mihov, and Dr. Mauricio Rodriguez, all of the Neeley School of Business at TCU, appears in the April issue of the prestigious Journal of Banking & Finance.

Examined were data from Thompson Financial for new issues involving floating and fixed-rate public debt, private placements, and SEC Rule 144A debt. Information was available for public issues beginning in 1970, private issues beginning in 1980, and Rule 144A issues beginning in 1990. For each type of issue, figures were gathered from first availability through the end of 2006. Data were also obtained through DealScan for 1987-2003.

Excluded were debt issues from non-U.S. companies, financial firms, nonprofits, and governmental entities, and transactions in foreign currencies.

The researchers examined characteristics such as loan size, loan pricing, length to maturity, and call and put features. Also scrutinized were movements in interest rates based on BAA-rated corporate bonds, 90-day Treasury Bills, and 10-year constant maturity Treasuries. All dollar amounts were adjusted to 2001 Consumer Price Index values.

"Our study initially found some indication for the ability of managers to predict rate changes, but once we took into account the size of the loans, length of the loans, and the call and put features, we found a lack of timing success," says Dr. Barry.

"This suggests that while evidence for successful prediction may seem to be found with some types of issues during specific sub-periods, when increased detail is examined there is less evidence," he says.

The implications are that corporate managers should divest themselves of any belief that they can foresee the future of the debt market.

"It's important for managers to understand they do not have the ability to predict the future of interest rates," Dr. Barry says emphatically.

But he and his colleagues point out a potential exception to their conclusions.

Rule 144A issues exhibited the strongest apparent evidence for successful market timing during certain sub-periods examined. Rule 144A issues are exempt from SEC registration, making the transactions quicker and easier, thus possibly providing a market timing advantage.

Says Dr. Mihov: "The evidence for timing with Rule 144A issues may be a valid observation because of their quickness of issuance in front of changes in interest rates. However, these results might be specific to the period, in that Rule 144A issues do not capture data from the 1970s and 1980s because they have only been in existence since 1990. As this market matures, additional evidence will be needed to verify the timing success of 144A issues."