Political sensitivity and government oversight in the US corporate bond market: evidence from federal contractors

• Pages: 1173-1189
• DOI: https://doi.org/10.1108/CG-07-2019-0217
• Date: 08 September 2020
• Published date: 08 September 2020
• Author: Karen Ann Craig,Brandy Hadley
• Subject Matter: Strategy,Corporate governance

Political sensitivity and government

oversight in the US corporate bond

market: evidence from federal contractors

Karen Ann Craig and Brandy Hadley

Abstract

Purpose –This paper aims to investigate the political cost hypothesis and the effects of political

sensitivity-induced governance in the US bond market by using yield spreads from bonds issuedby a

diversesample of US government contractors.

Design/methodology/approach –Fixed effects regressionanalysis is used to test the relation between

the politicalsensitivity of government contractorfirms and their cost of debt.

Findings –Resultsillustrated that government contractorswith greater political sensitivity are associated

with larger yield spreads,indicating that bondholders requirea premium when firms endure the costs of

increased political oversight and the threat of outside intervention, reducing the certainty of future

income. However, despite the overall positive impact of political sensitivity on bond yield spreads on

average, the authors found that the additional government oversight is associated with lower spreads

when the firmis facing greater repayment risk.

Practical implications –Despite the benefits of winning a governmentcontract, this paper identifies a

direct financial cost of increased political sensitivity because of additional firm oversight and potential

intervention. Importantly, it also finds that this governance is valued by bondholders when faced with

increased risk. Firms must balance their desire for government receipts with the costs and benefits of

dependenceon those expenditures.

Originality/value –This paper contributes to theliterature in its exploration of political sensitivity as an

important determinantof the cost of debt for corporate government contractors.Specifically, the authors

document a significant risk premium in bond pricing because of the joint effects of the visibility and

importanceof government contracts to the firm.

Keywords Governance, Cost of debt, Yield spreads, Corporate bonds, Political cost hypothesis,

Political sensitivity

Paper type Research paper

Introduction

Corporate governance is a means to protect the interest of corporate shareholders. It lies

behind every firm decision and impacts capital structure, allocation of resources and helps

to ensure optimal returns. Prior studies [1] have shown that politics can influence corporate

governance through many channels. Specifically, we evaluate the corporate governance

role of politics in the oversight of government contractors through the direct and indirect

influence of government relationships. According to the political costs hypothesis, firms that

are dependent on government contractslikely face additional scrutiny from the government,

media and watchdog organizations impactingtheir behavior (Watts and Zimmerman, 1986;

Flammer, 2018).

The impact of this scrutiny may or may not be beneficial to stakeholders. The scrutiny may

provide a valuable corporate governance mechanism or it may only result in costly, but

Karen Ann Craig is based

at the Department of

Accounting and Finance,

Eastern Michigan

University, Ypsilanti,

Michigan, USA.

Brandy Hadley is based at

the Department of Finance,

Banking and Insurance,

Appalachian State

University, Boone, North

Carolina, USA.

Received 20 July 2019

Revised 30 January 2020

8 May 2020

14 May 2020

Accepted 26 May 2020

The authors would like to thank

our Financial Management

Association (FMA) discussant

and the FMA community for

contributing comments

regarding an earlier draft

(Craig and Hadley, 2017) and

other contributing discussants

and reviewers for their helpful

suggestions on this

manuscript. We would also like

to acknowledge the Corporate

Governance editors and

anonymous referees and are

grateful for their support.

DOI 10.1108/CG-07-2019-0217 VOL. 20 NO. 7 2020, pp. 1173-1189, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 1173

useless, oversight combined with value-destroying behavior. Therefore, we evaluate the

impact of this increased attention on inside stakeholders, specifically debtholders, who

have a vested interest in the corporate governance and behavior of thefirm. We investigate

if a firm’s political sensitivity, by way of government contracts, serves as a valuable

mechanism of corporate governance by decreasing the firm’s cost of debt. Strong

governance can decrease investors’ required rate of return by improving financial reporting

quality and reducing monitoringcosts (Zhu, 2014).

Corporate governance, the US bond market, the cost of debt and the components that

comprise yield spreads have been widely researched in the literature [2]. Although many

determinants of the cost of debt have been recognized, there are still many factors to be

identified and questions to be answered. Understanding the components of bond pricing

and the role corporate governance has on this pricing is an important research area

because of the implications to firms’costs of debt and therefore investors’ returns.

The political costs hypothesis states that firms sensitive to government oversight take

actions to deflect negative government reactions, which results in increased political costs

to the firm (Watts and Zimmerman, 1986). Most recently, these costs have been shown to

be present in politically sensitive government contractor firms in the form of electing to pay

higher tax rates (Mills, Nutter and Schwab, 2013) and constraining executive compensation

(Hadley, 2016) because of additional governance from the government, media and

watchdog organizations. Inaddition, politically sensitive firms are associated with increased

downward earnings management, conservative accounting practices and increased

voluntary disclosure [3]. To date, bondholders’ perception of political sensitivity has been

relatively unexplored. The impactof political sensitivity to a firm could result in a significantly

higher cost of debt if bondholders view government oversight and dependence as risky.

Therefore, it is important to understand the impact of government contracts on the cost of

corporate debt.

We use a government contractor settingto evaluate the impact of a firm’s political sensitivity

on issuing yield spreads. Government contractors provide a useful setting to evaluate the

impact of political sensitivity because of their diversity [4], their importance [5] and their

supplier–customer business relationship with a government agency. Through this

relationship, a level of firm political visibility and sensitivity arises because of the

stakeholder–customer position of the government, resulting in greater government, media

and watchdog scrutiny for the firm (Mills et al.,2013).

We analyze a sample of 1,065US federal government contractor corporate bonds to

evaluate the impact of political sensitivity and bargaining power on bond yield spreads, for

the contracting period 2011–2014. This represents a total of 222 unique government

contractor firms issuing bonds during this period. We find that government contractors with

greater political sensitivity, due to the size of their contracts at the time of issue, are

associated with larger yield spreads. This indicates that bondholders require a premium

when the certainty of future income is reduced because of government dependence and

the threat of political intervention. We explore the underlying mechanisms of variation in

earnings management and tax paying behavior as channels for this relationship in our

sample. We find evidence consistent with increased earnings management being jointly

linked to political sensitivity and increased yields. However, we do not find evidence of a

consistent relation with increased tax paying behavior as the channel. Importantly, we find

that political sensitivity and increased likelihood of government oversight are linked with a

lower cost of debt when the firm is facing greater repayment risk. This indicates that the

government relationship acts to control the cost of debt and lower corporate bond risk in

these situations.

Our findings contribute to the literature in a number of ways. We add to the research on

governance, politically sensitive firms and the political costs hypothesis through our finding

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