Companies with greater default risk cut investment more sharply after global risk premiums rise, according to October research tracing how financial-market conditions reach spending on productive assets.
The NBER working paper, by Caitlin Hegarty, Matias Moretti, Pablo Ottonello and Diego J. Perez, combines company and bond-market evidence with an economic model. It is preliminary and has not been peer-reviewed.
The empirical analysis centers on publicly traded firms in six Latin American economies, with additional countries used for validation. Investment is measured through changes in the book value of property, plant and equipment.
The authors find larger investment contractions among riskier firms after increases in the excess bond premium, a measure intended to separate financing-market pressure from expected default risk.
A borrower’s risk is only part of the price
A company borrowing money must persuade a lender that future repayments justify the money committed today. The price reflects more than the borrower’s expected sales.
The lender also has alternatives, its own funding constraints and a willingness to absorb uncertainty. If investors become less willing to carry risk, a company can face more expensive financing even without an immediate deterioration in its operations.
The Federal Reserve’s explanation of asset valuations describes a risk premium as the additional expected return investors demand for holding a risky asset instead of a safer Treasury security.
For a bond, the credit spread is the gap between its yield and a comparable safer benchmark. That spread can include compensation for expected losses, uncertainty and other influences. It is not a pure reading of the issuer’s probability of failure.
In a Federal Reserve explanation of risk premiums, Donald Kohn separated compensation for expected credit losses from extra compensation for uncertain outcomes. Separating those two costs helps explain why changing investor appetite can reach otherwise viable investment plans.
Financial conditions affect which projects go ahead
A business planning new equipment compares what the project is expected to earn with the cost and terms of funding it. More expensive finance can make an expansion less attractive even if the equipment’s expected operating performance is unchanged.
Timing matters too. A project may require substantial payments before it produces revenue. Refinancing a loan during that interval creates a different exposure from securing funding that lasts through construction and the early operating period.
Our earlier coverage of borrowing access after an initial public offering examined how a company’s own financing options can widen. The new paper addresses pressure coming from the international financial system.
The researchers’ model links the pass-through of global risk pricing to how debt repayments respond to global shocks. Policies that smooth cash flows can reduce that exposure within the model; those results are simulations, not evaluations of a universally effective policy.
A business’s sales market and its source of finance can also be in different places. A lender repricing risk internationally may affect a firm that mainly supplies local customers.
Cash needs and financial resilience are different from accounting profit
A profitable company can still have a difficult funding timetable. Customers may pay after suppliers and employees have to be paid, while equipment purchases create cash demands before the resulting output is sold.
That timetable affects how long a company can postpone borrowing or absorb a change in financing terms. Accounting earnings, cash available today and access to another credit line each describe a different part of its position.
The study’s historical company data and model do not forecast the timing of the next investment downturn. Listed companies also differ from the many small businesses absent from the main empirical sample.
For suppliers of machinery, construction services and other investment goods, financing conditions belong alongside customer orders when assessing demand. An expansion can remain commercially attractive while its buyer waits for funding terms that make it affordable.
