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Loan rates vs. public debt rates: do loan rates reflect special values to the borrower or information intensive lending?

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  • Douglas O. Cook
  • Lewis J. Spellman

Abstract

Bank loans and public debt are competing funding sources for firms without barriers to public debt markets. With firms seeking the least costly funding and investors in both public debt markets and bank loan markets seeking the highest return for the same firm risk, it would seem that arbitrage on both sides of the market would cause the law of one price to prevail. However, there are two bodies of literature suggesting that loan rates and public debt rates for the same firm might be different. The arguments hinge either on bank loan ?special values?, allowing a bank lender to extract a positive lending rent above the same firms contemporaneous public market rate, or on lender information monopolies, whereby firms provide private information to ?informed? bank lenders that justify on the basis of risk, a loan rate discount relative to the rate assigned by the less knowledgeable public markets (negative lending rent). In general, we find negative lending rents which become more negative as the firm?s credit rating declines. This result occurs because while firm loan rates rise with a declining firm credit rating, they do not rise as fast as public market rates. This empirical result is consistent with the informed lender thesis.

Suggested Citation

  • Douglas O. Cook & Lewis J. Spellman, 2006. "Loan rates vs. public debt rates: do loan rates reflect special values to the borrower or information intensive lending?," Proceedings 1028, Federal Reserve Bank of Chicago.
    • Handle: RePEc:fip:fedhpr:1028
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    Keywords

    Bank loans; Debts; Public;
    All these keywords.

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