Following the financial crisis, UK companies revised their spending and financing decisions dramatically. They reduced investment by around 13% in real terms between 2008 and 2012 (Besley and Van Reenen 2013, Haddow et al. 2013). But during that same period, corporate bond issuance by UK companies was strong, with record corporate bond issuance in 2012. Taken at face value, this might appear puzzling, as one might expect strong bond issuance to feed into stronger investment.
In a recent Bank of England Quarterly Bulletin article (Farrant et al. 2013), we examine some alternative explanations for this pattern of corporate behaviour, which have different implications for the real economy:
- That companies have been issuing bonds in order to restructure their balance sheets, rather than to invest;
- That companies that issue bonds do not matter for UK investment; and
- That the aggregate data reflect heterogeneity across firms, with those companies issuing bonds investing, while the weakness in aggregate data reflects investment by companies that do not issue bonds.
We draw on three main data sources: aggregate statistics on corporate liabilities and investment; a company-level database for publicly listed firms constructed at the Bank of England; and publicly available surveys.
Have UK companies been issuing bonds in order to change the structure of their balance sheets?
There is some evidence that UK companies have restructured their balance sheets, and that this is one of the factors behind the recent strength in bond issuance. This is seen in both aggregate and company-level data. According to ONS data, for example, bonds accounted for 7% of the stock of UK companies’ financial liabilities prior to the crisis in 2007. That has since risen to 10% in 2013 Q2. The use of loans as a source of finance, meanwhile, has fallen from its peak of 38% of UK PNFCs’ financial liabilities in 2009 Q1, to 27% in 2013 Q2.
- One reason why companies are likely to have restructured their balance sheets since 2009 relates to the sharp contraction in bank credit following the financial crisis.
The Deloitte CFO Survey of large corporates, for example, showed that bank borrowing went from being the most attractive source of funding in 2007 and 2008 – compared with raising funds through bond and equity issuance – to the least attractive in 2009.
- Companies may have also restructured their balance sheets in response to the Bank of England’s asset purchase programme – ‘quantitative easing’ (QE) – to the extent that it reduced the term premium in corporate bond yields.
Federal Reserve Governor Stein (2012) has put forward an argument along these lines, suggesting that companies may respond differently when interest rates move because of a change in term premia rather than expected policy rates, particularly when term premia are negative. When term premia are negative — say a company can issue a ten-year bond at an annualised rate of 2%, but expects the sequence of rolled-over short-term rates to average 3% — then the company may be incentivised to restructure its balance sheet. This is because it could issue long-term debt at 2%, and use these funds to pay back short-term debt, repurchase equity, or buy short-term securities, as all these adjustments yield an effective return of 3%. As a result, the ‘hurdle rate’ for capital investment remains pinned at 3% — the return a company can earn if it invests in financial assets instead. According to this argument, once term premia become negative, further QE may encourage bond issuance but has less effect on investment.
In our article, we present a model that tries to test this hypothesis formally for UK companies. We find that UK companies respond to a decline in long-term interest rates by increasing investment, even when the decline in interest rates comes about because of a fall in term premia, and term premia are negative. This suggests that QE has not encouraged UK companies to issue bonds to restructure their balance sheets at the expense of any increase in their investment spending.
Do companies that issue bonds matter for UK’s growth prospects?
One reason why corporate bond issuance has been strong in the UK since 2009, while investment has been weak, could be that companies issuing bonds do not matter for UK investment. This could be the case if the corporate bond market is not available to most companies and, so, is not an important source of funds for UK companies in aggregate. Alternatively, it could reflect companies that have access to the bond market not investing very much in the UK.
We do not find evidence in support of this explanation. The corporate bond market has become increasingly important as a source of finance for UK companies over time, with record bond issuance in 2012. That strength has broadly continued in 2013. According to our estimates, the number of companies issuing bonds has also increased, particularly since the beginning of the financial crisis in 2007. And so has the number of companies accessing the corporate bond market for the first time.
Our firm-level database of publicly listed companies can also help assess the importance to the UK economy of companies that issue bonds. We find that these companies tend to be large – in 2012, none of the publicly listed companies that have issued bonds in the past would be classified as a small or medium-sized enterprise. But, despite this, the companies that have access to the bond market play an important role in influencing UK growth prospects. We estimate that all listed UK companies accounted for around 45% of UK business investment in 2012.1 And while only a few of these listed companies also issue bonds, those that do accounted for around a third of UK business investment. Taken together with the recent strength in bond issuance, there would, therefore, appear to be little support for the strength in corporate bond issuance at a time of weak investment being a reflection of bond issuers not being important for the UK economy.
Is the aggregate picture masking different behaviour across companies?
Aggregate data could also be masking heterogeneity across UK companies. Chart 1 shows growth rates of business investment, using both company-level data and aggregate data. Up until 2009, there was a close correlation between the aggregate business investment growth rate (blue line) and investment by companies issuing both bonds and equity (magenta line), suggesting no obvious bias in investment behaviour between the median company in the company-level database, and the aggregate data.
Figure 1. Annual growth in UK real business investment and median annual growth in real capital expenditure for firms in the company-level database
Sources: Dealogic, ONS, Thomson Reuters Datastream Worldscope and Bank calculations.
Since 2010, however, while aggregate UK business investment has remained weak, investment by companies with access to capital markets recovered sharply. This suggests that improvements in capital market conditions have allowed companies with access to those capital markets to undertake investment. This strength in investment in 2010 and 2011, combined with the weakness in aggregate UK business investment over that period, suggests that companies without access to capital markets may have reduced their investment markedly in 2010 and 2011.
In 2012, however, investment growth has fallen for companies that access capital markets, despite their continued strong bond issuance. This suggests that other factors, besides the availability of finance, are likely to have influenced companies’ investment behaviour in 2012. The Deloitte CFO Survey suggests that large companies anticipated a slowdown in investment in late 2011. The deterioration in expectations for investment over the following twelve months appeared to be linked with an increase in financial and economic uncertainty, and a decrease in optimism regarding the economic outlook. Looking ahead, optimism and CFOs’ expectations of UK companies’ investment have since risen, suggesting that investment growth by larger companies with bond market access may have picked up again in 2013, despite the continuing weakness in the aggregate investment data.2 There may also be a lag between companies raising finance and undertaking investment projects, which may suggest that some of the record bond issuance in 2012 could have been used to support investment in 2013.
Understanding why aggregate UK business investment has remained weak, while corporate bond issuance has been strong, is important in the context of understanding the role public capital markets play for UK companies. And different explanations for this pattern have different implications for the real economy. There is some evidence that UK companies have been raising bond finance because of a desire to restructure their balance sheets — and in particular, to reduce their reliance on banks.
Much of the evidence suggests that the pattern of weak investment in 2010 and 2011 at a time of strong corporate bond issuance reflects heterogeneity among companies, with those with capital market access investing, and those without – not, such that overall aggregate investment remained weak. That might suggest that an