Government economic policy uncertainty and corporate debt contracting

• Published date: 01 March 2022
• Author: Dung T. T. Tran,Hieu V. Phan
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/irfi.12347

ORIGINAL ARTICLE

Government economic policy uncertainty and

corporate debt contracting

Dung T. T. Tran

1,2

| Hieu V. Phan

1

1

Manning School of Business, University of

Massachusetts Lowell, Lowell, Massachusetts

2

School of Banking and Finance, National

Economics University, Hanoi, Vietnam

Correspondence

Dung T. T. Tran, Manning School of Business,

University of Massachusetts Lowell,

72 University Avenue, Lowell, MA 01854,

USA.

Email: dung_tran@student.uml.edu

Abstract

We examine the relation between government economic

policy uncertainty and debt contracting of U.S. public firms.

We find that policy uncertainty is associated with more

stringent debt terms, such as shorter debt maturity, higher

cost of debt, and more restrictive debt covenants, and these

relations are concentrated in financially constrained firms.

Further analysis indicates that the negative real effects of

policy uncertainty documented in the literature are more

pronounced for financially constrained firms. Overall, our

evidence suggests that policy uncertainty dampens external

financing and exacerbates firms' financial constraints, lead-

ing to their investment delays.

KEYWORDS

cost of capital, cost of debt, debt maturity, financial constraints,

investment, policy uncertainty

JEL CLASSIFICATION

G30; G32

1|INTRODUCTION

Government economic policies alter the environment in which firms operate. The process of debating and adopting

new economic policies usually takes considerable time and the outcomes can be uncertain. From the real option per-

spective, uncertainty increases the value of waiting for new information about the profitability of the projects,

We appreciate comments from participants at the 2017 FMA Annual Meeting, 2017 MFA Annual Meeting, 2018 Vietnam Finance Association

International (VFAI) Annual Meeting, and finance department seminar at the University of Massachusetts Lowell. All errors remain the sole responsibility of

the authors.

Received: 17 January 2019 Revised: 11 January 2021 Accepted: 24 January 2021

DOI: 10.1111/irfi.12347

© 2021 International Review of Finance Ltd.

International Review of Finance. 2022;22:169–199. wileyonlinelibrary.com/journal/irfi 169

leading to investment delays, particularly when investment is irreversible (Bernanke, 1983; Rodrik, 1991). Alterna-

tively, uncertainty can increase financial market frictions (Arellano, Bai, & Kehoe, 2018; Christiano, Motto, &

Rostagno, 2014; Gilchrist, Sim, & Zakrajsek, 2014) that impede firms' external financing and real investments. Empiri-

cal evidence suggests that government economic policy uncertainty adversely affects corporate investments

(Gulen & Ion, 2016; Nguyen & Phan, 2017) and corporate trade credit (Jory, Khieu, Ngo, & Phan, 2020), and induces

firms to increase precautionary cash holdings (Phan, Nguyen, Nguyen, & Hegde, 2019). Brogaard and Detzel (2015)

find that policy uncertainty is positively related to excess market returns and suggest that policy uncertainty is an

important risk factor for equities. Although debt is a major source of corporate financing, which is prone to market

frictions, no prior research has examined the relation between policy uncertainty and corporate debt contracting. In

this study, we investigate the relation between government economic policy uncertainty and corporate debt matu-

rity structure, cost of debt, and debt covenants of U.S. public firms.

The structure of corporate debt maturity, that is, the use of short-term versus long-term debt, is an integrated

component of a firm's financial policy. Previous studies document that a firm's debt maturity structure is closely

related to its financial leverage (Barclay, Marx, & Smith Jr, 2003; Billett, King, & Mauer, 2007), corporate liquidity

(Harford, Klasa, & Maxwell, 2014), real investments (Aivazian, Ge, & Qiu, 2005; Almeida, Campello, Laranjeira, &

Weisbenner, 2011; Duchin, Ozbas, & Sensoy, 2010), and stock performance (Datta, Iskandar-Datta, & Raman, 2000).

Between short-term and long-term debt, the former can mitigate shareholder-creditor agency problems in the form

of underinvestment or asset substitutions (Barnea, Haugen, & Senbet, 1980; Jensen & Meckling, 1976; Leland &

Toft, 1996; Myers, 1977), and provide a monitoring device for creditors (Rajan & Winton, 1995; Stulz, 2000). Short-

term debt also allows firms to preserve debt capacity for investment in future growth opportunities (Graham &

Harvey, 2001). However, short-term debt financing subjects firms to liquidity risk because it requires more frequent

renegotiations, exposing the borrowing firms to the risk of insolvency if they fail to honor their debt payment obliga-

tions (Jensen, 1986).

A firm's debt terms and its corporate investments are also closely related. Aivazian et al. (2005) find a negative

relation between the ratio of long-term debt and investment of firms with high growth opportunities. Almeida

et al. (2011) report that debt maturity had important real effects for industrial firms during the 2007–2008 financial

crisis. Specifically, they find that firms that had a large proportion of long-term debt maturing right after the onset of

the financial crisis experienced a sharp decrease in investments. Chava and Roberts (2008) documentthat a financial

covenant violation by the borrowing firm may lead to a decrease in capital investment due to a possible transfer of

control rights. Finally, all else being equal, a higher cost of capital decreases the profitability of an investment project,

which has a negative implication for the project feasibility.

Policy uncertainty can increase firms' cash flow volatility, heightening their default risk in the bad states of the

world. Faced with the borrowers' higher default risks induced by high policy uncertainty, creditors may choose to

protect their interests by imposing more stringent debt terms, such as shorter term debt, higher debt cost, and more

restrictive debt covenants. We test these hypotheses in this research.

We employ the government economic policy uncertainty index developed by Baker et al. (2016; hereinafter

labeled BBD index) as a proxy for economic policy uncertainty in our research. The BBD index comprises of three

components: the frequency of news media references to economic policy uncertainty, the number of federal tax

code provisions set to expire in future years, and the extent of forecaster disagreement over future inflation and fed-

eral government purchases. We use the new bond issues data obtained from the SDC Platinum database to examine

the effects of policy uncertainty on debt maturity and the cost of debt in our main analysis.

Using a sample that includes 6,380 firm-year observations of 1,020 U.S. public firms that issued bonds over the

period 1985–2015, we find robust evidence of a negative relation between policy uncertainty and debt maturity.

The effect of policy uncertainty on debt maturity is also economically important. Our estimation indicates that, hold-

ing other variables unchanged at their sample means, a 100% increase in policy uncertainty is associated with 19.4%

decrease in the maturity, which is equivalent to 2.35 years, of new debt issues. Our finding persists when we use the

debt maturity measures from the balance sheet obtained from the Compustat database.

170 TRAN AND PHAN