The Loan-Bond Spread

Bank loans serve as a critical channel for firms to raise external capital and are typically considered the first resort in debt financing when firms have difficulty accessing public bond markets. However, because loans are issued in private markets and traded between banks with limited liquidity and transparency, their costs are difficult to assess. In this project, we propose to assess bank loan costs, using the cost of bonds traded in public markets as the benchmark. Using a structural credit risk model and market prices of bonds and loans, we construct a novel measure - the loan-bond spread (LBS) - to evaluate the relative pricing between loans and bonds of the same firm. The LBS is the difference between actual loan spreads and bond-implied loan spreads. Intuitively, actual loan spreads reflect how banks trading in private markets view firms' financial conditions, while bond-implied loan spreads reflect how bond investors trading in public markets view the same firms' financial health. A high loan-bond spread indicates that loan prices in private markets are relatively low compared to the same firm's bonds. In our preliminary results, we first confirm that our loan-bond spread adequately captures the relative mispricing between private loans and public bonds. The loan-bond spread positively relates to future loan returns, with a risk-adjusted spread of 4.01% between high- and low-LBS firms. More importantly, we externally validate our measure through managerial financial decisions. We find that the underpricing of loans relative to bonds induces managers to buy back loans, with an estimate of -0.31(t-statistic = -7.66), while actual loan yields have no effect on debt structure adjustment. This contrast demonstrates that managers time the market and arbitrage both loan and bond markets. Taken together, we make four contributions. First, we construct the first measure to assess the relative mispricing of private loans using publicly traded bonds, for both public and private firms. Second, we provide the first empirical evidence that managers time the market and take advantage of relative mispricing to adjust firms' debt structure. We plan to develop a structural model of debt structure choice that incorporates market segmentation and liquidation risk. Third, our planned extension to private firms and market segmentation analysis will allow us to assess the difficulties of credit access faced by private firms. Fourth, our planned study on debt structure changes in response to monetary shocks will shed light on credit (mis)allocation.