Any prudent corporation keeps a rainy day fund, a cache of cash reserves to see it through difficult times ahead. But lately, pundits and politicians have accused firms of sitting on too much cash and slowing the pace of economic recovery.
New research by Jarrad Harford of the University of Washington Foster School of Business confirms that American corporations have doubled their cash holdings, as a percentage of assets, over the past 30 years. His study also identifies a key cause: the marked shortening in the maturity of long-term corporate debt over the same period. This increases both the refinancing risk when that debt must be rolled-over, and the rationale for keeping more cash to mitigate that risk.
“Researchers have been puzzling over why the rainy day fund has doubled in the last three decades,” says Harford, the Marion B. Ingersoll Professor of Finance at Foster. “We observe that the maturity of long-term debt of US firms has significantly decreased from 1980 to 2008, and this phenomenon helps explain an important piece of the contemporaneous large increase in the cash holdings of US firms.”
The cause of this sharp increase in corporate cash has remained a big mystery because it involves big money. According to Standard & Poor’s Capital IQ, the firms that make up its S&P 500 Index together hold in excess of $1 trillion in reserves. Across the US economy, corporations doubled their cash holdings, as a percentage of assets, from 1980 and 2008.
But what else changed, over those three decades, that might lead corporations to hold on to more of their profits?
Harford and co-authors Sandy Klasa of the University of Arizona and William Maxwell of Southern Methodist University found that the credit markets tightened considerably over the same period. The average bond maturity for US corporations fell from 16.6 years from 1985-1998 to just 11.3 years in the years 2005-2008 (they halted their analysis at 2008 to throw out the effects of the global financial crisis).
This reduction in average time to maturity brings an increase in refinancing or rollover risk. In other words, having to refinance a long-term loan more frequently means a greater chance that a firm will have to cope with deteriorating credit terms or undervaluation by lenders.
“One way you can manage that risk is to have more cash reserves to afford some flexibility to refinance and to cushion the blow to cash flow,” Harford says. “This allows managers a hedge against refinancing at bad terms, a cushion to hold off or refinance part of the debt, or the resources to pay off some of the debt.”
The study demonstrates that declining corporate debt maturity explains as much as one-third of this trend in cash reserves. It also finds that firms that keep larger cash reserves are, indeed, able to maintain competitive investment through credit crunches.
“The strategy does work,” Harford says.
Too much cash?
Even with his latest finding, Harford refutes the charges that significantly greater corporate cash reserves are hampering the economy as it claws its way out of the Great Recession.
A follow-up study indicates that firms’ “cash” holdings are more active than we think. Whether invested aggressively or socked in a bank, American corporate cash is spurring the US economy.
“This business about corporations just sitting on cash is bunk,” Harford says. “It’s not like they bury it in the back yard. Many firms are investing ‘cash’ in US treasuries, US equities, US bonds—investing back into the economy. And when firms put cash in the bank, it’s also put to work in the economy. It may not be working for the firm that earned it, but it’s working for someone else in the economy.”
“Refinancing Risk and Cash Holdings” is forthcoming in the Journal of Finance.