The Value of Corporate Diversification: A Debt Market Perspective *

Abstract

Theoretical arguments suggest that a firm’s diversification strategy affects its credit risk. The co-insurance theory argues that imperfectly correlated cash flow streams of a diversified firm’s segments reduce the variability of aggregated earnings, thus lowering the credit risk. In addition, the agency theory suggests that agency conflicts specific to diversified firms can increase or decrease the credit risk. We empirically test these theoretical predictions by investigating the effect of corporate industrial diversification on the cost of public debt financing. For a broad set of diversification measures and empirical specifications, we document significantly lower bond yields when firms diversify their operations. Further, we find that the negative relationship between diversification and bond yields is much more pronounced when firms diversify across unrelated industrial segments, and when diversification is associated with a lower inter-segment cash flow correlation, indicating that the results are more consistent with the co-insurance argument. This inference is further strengthened by our finding that the negative effect of diversification on the cost of public debt financing is also present in a sample of syndicated bank loans where agency problems are addressed through strong monitoring features rather than by adjusting the loan spread.

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