Exorbitant privilege? Quantitative easing and the bond market subsidy of prospective fallen angels

Summary

Focus

Massive issuance by BBB-rated firms has propelled growth of the US corporate bond market since the Great Financial Crisis. In this paper we investigate how quantitative easing (QE) boosted demand for BBB bonds and how it interacted with credit rating agencies' leniency to generate capital misallocation reminiscent of zombie lending.

Contribution

Riskier firms typically borrow at higher interest rates compared with safer firms because investors require compensation for taking on more risk. However, this relationship has been turned on its head in the massive US BBB corporate bond market since the Great Financial Crisis. We show that prospective fallen angels – BBB-rated issuers vulnerable to being downgraded – paid 13 basis points less to borrow in the corporate bond market compared with safer BBB-rated peers. If these prospective fallen angels had been downgraded to the high-yield market, their funding costs would have risen by around $300 billion over the period from 2009 to 2019, according to our back of the envelope calculation.

Findings

The prospective fallen angel subsidy can be attributed to an interaction between QE purchases and the leniency of credit rating agencies. Investors with portfolios most exposed to QE increased their demand for bonds issued by prospective fallen angels. This lowered the issuers' financing costs. Prospective fallen angels met this demand by issuing bonds, largely to finance mergers and acquisitions (M&A), which served two purposes. Firstly, M&A delayed credit rating downgrades. Secondly it helped the firms to grow their market shares. The bond market subsidy of prospective fallen angels adversely impacted competitors' employment, investment and sales. In addition, the early stages of the Covid-19 crisis exposed the vulnerability of prospective fallen angels. In just a few weeks at the beginning of 2020, vulnerable BBB-rated firms that engaged in M&A were more likely to be downgraded, and by more notches.

Abstract

We document capital misallocation in the U.S. investment-grade (IG) corporate bond market, driven by quantitative easing (QE). Prospective fallen angels – risky firms just above the IG rating cutoff – enjoyed subsidised bond financing since 2009, especially when the scale of QE purchases peaked and from IG-focused investors that held more securities purchased in QE programs. The benefiting firms used this privilege to fund risky acquisitions and increase market share, exploiting the reluctance of credit rating agencies to downgrade post-M&A and adversely affecting competitors' employment and investment. Eventually, these firms suffered more severe downgrades at the onset of the pandemic.

JEL classification: E31, E44, G21.

Keywords: corporate bond market, investment-grade bonds, large-scale asset purchases (LSAP), credit ratings, credit ratings inflation.