What Is Debt Signaling?
Announcements made about a company taking on debt (e.g., by issuing new bonds) are typically seen as positive news as it can signal the company is creditworthy and is raising capital for the purposes of growth.
- Debt signaling theory suggests that corporate debt decisions can serve as a reliable signal for outside equity investors.
- When a company increases its debt capital, especially at favorable interest rates, it signals that the company is both creditworthy and capable of going after growth opportunities, making it a positive signal.
- If, on the other hand, a company is forced to reduce its debt load or seeks capital through an equity offering, it may be seen by investors as a negative signal.
Understanding Debt Signaling
In the world of finances and economics, corporations are always seeking new growth opportunities. Investors usually determine whether or not these companies are undertaking growth opportunities by looking to direct or indirect signals they receive from corporations.
Sometimes those signals come from the company’s management team, but they can also come from actions made by the company, including when the company says it will take on more debt. These are referred to as debt signals. These debt signals can be both positive or negative, both of which can have a big impact on the way a company's stock performs.
Companies can raise direct capital in two primary ways: through debt and through equity. Debt is often the preferred method of financing over raising equity, since the cost of equity is usually higher than debt. Issuing equity is also a means of diluting ownership of a company to new investors, who get voting rights and a residual claim to profits and growth. When a company makes a decision to utilize debt financing through issuing corporate bonds, investors may believe the company is on solid financial footing and actively seeking growth opportunities at lower financing costs than via issuing stock.
Positive & Negative Debt Signals
The type of financing can signal the future of the company’s financial position and any prospects for projects the company may have. When a company announces that it will take on more debt (typically for a new project), that signals sound financial health to investors and to the market, making it a positive debt signal. So when a company wants to take on more debt, that means it is committed to paying interest on it. The company also indicates that it believes strongly in its project (and therefore, its financial health) and believes that it will provide quick returns — enough to pay down the debt and to provide (financial) benefit to its investors.
If, on the other hand, any future debt is reduced, investors may see this as a sign that the company is unable to make its interest payments and is in a weak financial situation. Similarly, if the company chooses to raise new equity rather than take on any debt, this is a negative debt signal. This means that a company does not have enough confidence in its financial situation or its projects, does not have enough profits, or just cannot raise enough debt. -
Debt Signaling Example
In October 2017, online streaming and content producer Netflix (NFLX) announced it was going to raise about $1.6 billion in debt. The company said it would use the funds for general purposes, including funding for new content. This was seen as a positive step for the company, and therefore as a positive debt signal. Investors were seemingly pleased by the news, as the company's stock increased immediately following the announcement. By 2020, the company had borrowed over $16 billion from creditors.
In 2021, the company then announced that it would no longer need to raise external debt financing for its day-to-day operations, signaling that it was generating enough revenue to cover its operating costs. Netflix was again using debt - in this case announcing a cessation of new bond issues for the time being - to signal its financial strength to shareholders. By mid-2022, Netflix had reduced its overall long-term debt to around $14.5 billion.
What Is Signaling Theory in Finance?
Signaling theory is the belief that information on a company's financial health is not available to all parties in a market at the same time. Since company insiders like executives and board members have more information about their company's prospects than the wider public, the decisions they make can reveal information about the company's finances. Dividends or stock buybacks could indicate that a company's management expects future growth, while stock or debt issuances could be less favorable.
How Does Debt Signaling Work?
Corporations' announcements about their debt can be a reliable signal for outside equity investors, by alleviating certain information asymmetries that exist between insiders and the investing public. If a company issues new bonds, it can signal that it is growing and is creditworthy enough to find buyers.
Why Do Companies Raise Debt Capital?
Companies often raise debt capital (i.e., borrow money) in the form of loans orby issuing bonds in order to gain the funding they need to operate and grow. Debt may be preferred to raising equity capital (selling shares) as debt does not involve relinquishing any ownership stake or voting rights to creditors. Debt may also be less costly than equity and come with certain tax advantages.