Digital Strategies in Bond Markets

Why Digital Strategies Matter in Bond Markets

Information technology (IT) investments are often valued favorably by the stock market because of their strategic nature and important role in influencing revenue and profit growth of firms. However, new research by professors Sunil Mithas and Michael Kimbrough at the University of Maryland’s Robert H. Smith School of Business, with Keongtae Kim, a Smith School PhD graduate and now assistant professor at the Chinese University of Hong Kong, reveals that bond markets value IT investments differently than stock markets according to the strategic roles of IT in industries and the types of risks they create.

Bond markets are the single-largest source of financing for U.S. firms. In 2016, firms in the United States raised $1.49 trillion through corporate bonds, surpassing by a wide margin funds financed through stock markets. Technology firms such as Tesla, Amazon and Microsoft frequently use bond markets to access capital to buy back shares or for their strategic growth investments.

Mithas and his coauthors found that credit rating agencies and bond investors favor IT investments in industries where IT is used mostly to automate business process and to facilitate richer information flows, as opposed to industries where IT transforms products, services and business models. One reason for this may be that although IT investments create higher future cash flows, these cash flows are especially volatile in transform industries — creating a downside risk in such industries for bondholders.

A key insight from the study is that IT investments are both associated with a firm’s operational performance and related to financing costs such as costs of debt. Thus, “senior managers may need to look beyond measuring the improvement in organizational performance driven by IT assets and also consider the potential financial benefits of increased IT capabilities, such as the willingness of corporate bond investors to accept lower financing costs,” Mithas and his coauthors say.

Because bondholders view IT investments in transform industries as riskier than in other industries, firms should use bond markets differently depending on which industries they operate in. Firms in transform industries may be able to lower their borrowing costs by sharing more information about IT investments with bond investors to alleviate their concerns about the risks of such investments. Likewise, firms in other industries may be able to lower their borrowing costs by making disclosures to bondholders that highlight the low risks and stable cash flows associated with their IT investments.

The findings are important as firms invest more in various emerging digital technologies such as artificial intelligence, blockchain, cloud computing and the Internet of things. Investments in such technologies will provide huge growth potential, but at the same time may pose serious risks in implementing them. Thus, understanding how such investments are viewed by shareholders and bondholders will be crucial for firms to get their digital stories right.

Read more: Information Technology Investments and Firm Risk Across Industries: Evidence from the Bond Market is featured in MIS Quarterly.