J. K. Dietrich - FBE 524 - Fall, 2005 Fixed Income Market (2): Corporate Debt and Equity Week 14 – November 23, 2005

J. K. Dietrich - FBE 524 - Fall, 2005

Fixed Income Market (2): Corporate Debt and Equity

Week 14 – November 23, 2005


Corporate Financing

In 2002, non-farm non-financial corporations hold title to $9.1 trillion in tangible assets (real estate of $4.7 trillion, equipment and software of $3.2 trillion, and inventories of $ 1.2 trillion, according to the Flow of Funds)

Households held $16.3 trillion, of which $12 trillion is real estate, consumer durables $2.9 trillion


Financing Corporate Investment

Investments can be financed in part by operating cash flows and retention of earnings

Internally generated cash flows (depreciation charges and retained earnings) finance most U.S. investment (e.g. $795.5 billion non-farm non-financial corporate investment in 2002, depreciation charges $827.5 billion)

Capital markets provide marginal financing


Debt versus Equity

Income from corporate assets are divided among claim-holders but total value of assets are not affected by the division of income (Modigliani-Miller theorems)

Principal-agent problems– Managers versus shareholders– Debt-holders versus residual claimants

Pecking order theory of corporate financing Tax advantage of debt


Taxation and Corporate Finance

Recent provisions which affected corporate financing– Investment tax credit (ITC)– Depreciation rules– Passive income (losses)

The Tax Reform Act of 1986 (TRA)– Reduced corporate tax rate– Removed many tax advantages


Impact of Taxation on Financing

Leasing– Banks and other financial firms have small capital

investments

– Banks and other financial firms have little depreciation

– Banks and leasing before 1986 Real-estate financing before 1986 Desirability of debt financing before and after

1986


Corporate Fixed-incomes Types of corporate debt instruments

– Short-term» Bank borrowings» Open-market borrowing (commercial paper and

bankers’ acceptances)

– Long-term» Secured (mortgages, secured debt)» Term loans, project financing» Unsecured debt

Public debt versus private debt placements


Major Sources of FundsCorporate Debt Markets 1960 1975 1985 1990 2004Total Financial Liabilities 229.6 1,086.9 3,308.2 4,729.4 10,254.1 Growth

Commercial Paper 0.8 9.6 72.2 116.9 101.7 11.6%Bank Loans 37.4 143.5 424.1 545.5 593.2 6.5%

Corporate Bonds 76.2 253.8 578.2 1,008.2 2,947.4 8.7%Mortgages 28.6 112.7 163.1 263.7 655.0 7.4%

Trade Payables 61.9 176.4 479.7 626.3 1,589.5 7.7%Market Value of Equity 365.2 761.2 1,916.9 2,967.1 7,910.4 7.2%

Share Commercial Paper 0.3% 0.9% 2.2% 2.5% 1.0%

Bank Loans 16.3% 13.2% 12.8% 11.5% 5.8%Corporate Bonds 33.2% 23.4% 17.5% 21.3% 28.7%

Mortgages 12.5% 10.4% 4.9% 5.6% 6.4%Trade Payables 27.0% 16.2% 14.5% 13.2% 15.5%

Debt/Equity Ratio 0.63 1.43 1.73 1.59 1.30

Source: Flow of Funds


Bank versus Public Financing

Banks traditionally were short-term lenders Banks had relationships with corporate (and other

business) borrowers– Access to information (e.g. deposits)– Special relationship to management

Banks monitored business borrowers– Covenants in loan agreements– Specialization in business monitoring– Cash flow lenders versus asset-based lending


Changing Bank Loan Market

Bank lending is global market:

U.S. banks have lost short-term customers to the open market in the form of open-market paper (commercial paper), to foreign banks, and to finance companies

Source: Flow of Funds

1960 1975 1985 1990 2004Bank Loans n.e.c.: 58.3 265.8 661.7 820.0 1,325.3

Commercial Banks 57.6 242.1 546.8 645.2 1,072.9 Foreign Banks 0.7 19.1 75.8 156.5 226.8

Foreign Bank Share 1.2% 7.2% 11.5% 19.1% 17.1%


Banks and Corporate Financing

Banks serve corporations by off-balance sheet and market-making activities– Underwriting commercial paper, issuing credit

guarantees/letters of credit backing borrowings – Risk-management services

Arranging ABS securities issues and advising corporate customers in private placements and mergers and acquisitions

Many think banks accept more risk


Banks versus of Open-Markets

U.S. corporate financing has moved extensively to greater reliance on markets for funds

Contrast with Europe and Japan until recently Corporate governance in the form of

shareholder activism is also highly developed in U.S. relative to foreign markets


Anglo-Saxon Finance

Focus on shareholder wealth maximization Markets and legal system provide discipline

for management Alternative to politics and negotiation

– Role of deregulation (airlines, trucking, utilities, financial services) is important

– Growth of institutional investors is important U.S. shareholder activism is recent and

perhaps we are seeing a precursor of future


Investors in Corporate Debt

* Total includes non-financial and financial corporate business bonds Source: Flow of Funds

Investment in Bonds: 1960 1975 1985 1990 2004Households 10.6 62.9 77.4 219.0 220.8

Rest of the World 0.7 4.6 126.4 217.2 1,765.1 Life Insurance Companies 48.1 105.5 280.6 566.9 1,753.4

Pension Funds 9.0 81.1 204.6 299.6 662.0 Mutual Funds 0.4 4.3 22.2 59.3 622.8

Share of Bonds* 1960 1975 1985 1990 2002Households 11.5% 18.7% 8.8% 12.8% 3.2%

Rest of the World 0.8% 1.4% 14.3% 12.7% 25.2%Life Insurance Companies 52.4% 31.4% 31.8% 33.2% 25.0%

Pension Funds 9.8% 24.1% 23.2% 17.6% 9.4%Mutual Funds 0.4% 1.3% 2.5% 3.5% 8.9%


Nature of Corporate Debt Indenture

– Covenants– Trustees and enforcement

Terms and series Security of income and principal

– Collateral and liens– Seniority of claim: debentures, junior debt

Special features: control, sinking funds, call features, conversion features


Bonds and Options (1)

Equity can be viewed as a call option on the value of the assets of the firm with the exercise price payment of debt claims

Bonds therefore can be viewed as a risk-free security combined with a put option on the assets of the firm at the debt face value

The default possibility is there the likelihood of exercise of the put on the firm’s assets


Risk-Free Bond and Asset Put

Asset Value0

Pay

off

Asset Value0

F

F

Risk-Free Bond

Asset Put

F

F

Risky Bond



Convertible bonds can be converted into some other security, usually common stock– Conversion ratio or price: e.g. each bond equals

20 shares means each $1,000 face value of debt can be converted into 50 shares of stock

– This is valuable if shares are worth more than $50– If bond pays interest and stock does not pay

dividends, investors will keep bonds even if price of stock is above $50 unless called


Convertible Bonds

Asset Value0

F

F

Convertible Risky Bond



A callable, convertible bond can thus be viewed as a risk-free bond with three options attached:– An asset put option (default possibility)– A bond call option (to force conversion)– A stock call option (value of stock)

These features can be used to price the bonds, hence the importance today of option pricing by so-called rocket scientists


Developments in Debt: Junk

Junk bonds are below investment grade (BBB) or non-rated bonds

Banks and insurance companies are restricted (in many instances) to investments in investment-grade bonds

Bonds can substitute for more expensive financing (e.g. bank loans) if principal-agent problems can be overcome– Junk bonds and free cash flow or quasi-equity


Developments: Structured Notes

There is no limit on the design of financial market instruments

The term fixed income refers to the fact that the payments are fixed by external factors but does not mean that payments are fixed

Structured notes take advantage of design flexibility to create fixed incomes which appeal to certain investors or issuers


Structured Note Innovations

Investors believe rates will stay low– Agencies issues inverse floating-rate notes– Rates tied to an index like 3-month LIBOR– Interest calculated with a formula like:

Catastrophe risk bonds for insurance companies where repayment of debt linked to an index of property-damage claims

LIBORmonth3318PaidRate


Asset-Backed Securities

Less well known corporate borrowers pool their obligations (like commercial paper) in a facility which borrows in corporate debt market

Example: collateralized loan obligation (CMO)

ABS issues earn high credit ratings through over-collateralization and guarantees of third parties (e.g. banks)


Banks Sell Loans

Loan syndications Banks sell loans from balance sheet (e.g.

collateralized loan obligations (CLOs))– Reduce capital requirements– Allow for faster growth

A part of the unbundling banks and other financial services, that is, unlinking funding activities from investing activities and other services


Capital Effect on $5 billion CLOAssumptions:

Loan portfolio yield

Bank funding costs

CLO execution spread

LIBOR + 75 basis points

LIBOR – 12.5 basis points

LIBOR + 19 basis points

Before CLO After CLO

Net spread earned $43,750,000

(L+75-L+12.5)

$28,000,000

(L+75-L+19)

Risk Based Capital $400,000,000

($5 bi. x 8%)

$100,000,000

(100% reserve)

Return on capital 10.9% 28.0%


Structure of CLO

Issuing Trust

Special Purpose

Vehicle (SPV)

Servicer (Bank)

UnaffiliatedInstitutionInvestor



Bank Lender

Business Borrowers


“The Stock Market”

Market for equity represents residual claims on real assets (plant, equipment, human capital, etc.)

There are many equity markets– Private equity (individual owners)– Partnership shares– Privately held corporations– Publicly traded corporations


Level of Stock Valuation Indices measure average values relative to some

base year and include some group of publicly traded stocks

Key U. S. stock indices are:– Dow-Jones (30 industrials, etc.)– NYSE - all stocks, plus industrial subgroups– S&P 500 industrials, other subgroups– NASDAQ– Other Indices: Russell indices, Wilshire 5000, Morgan

Stanley Capital International (MSCI)


Foreign Indices

Major market indices– London Stock Exchange (LSE) FTSE 100– Frankfurt (Deutsche Boerse) DAX – Paris CAC 40– Tokyo NIKKEI 225

Morgan Stanley Capital International country and regional indices

Dow-Jones indices


Integration/Fragmentation Buyers and sellers want the best prices and lowest

execution costs available anywhere Concentration of trading means more volume Most exchanges (e.g. NYSE, LSE) are owned by

broker seat-holders (members)– However, both NYSE and LSE may soon become

public companies– Many exchanges have converted (e.g. CME)

Concentration of trading can give markets monopoly power


Exchange Structure

Listed securities satisfy listing criteria Members own seats and agree to obey rules Members may have specialized functions,

as in NYSE– Specialists have obligations and privileges– Floor traders buy and sell for own account– Commission and floor brokers execute orders– Brokers execute customers’ orders either with

specialists, floor traders, or other brokers


U.S. Markets prior to 1975

NYSE

MWSE

ASE

CSE

BSE PSE


National Market System (NMS)

Amendments to the Securities Act passed in 1975

Ended commissions fixed by stock exchange rules which are reviewed by SEC

Called for creation of a national market system where traded integrated across exchanges

Eroded large exchange monopoly power


U.S. Markets after 1975

NYSE

MWSE

ASE

CSE

BSE PSE

Composite Tape

ITS


Trading in Listed Securities Exchange floor Upstairs market = large block transactions

arranged by member firms, reported on the exchange with floor participation required, and called the second market

Large block floor transactions arranged by non-member firms (off the floor), called the third market

Trades between institutions, fourth market


Over-the-Counter Markets Communication links between brokers and

multiple market makers who quote a price at which they will buy or sell securities

National Association of Securities Dealers (NASD) Automated Quotation System (NASDAQ) National Market System links market makers of larger companies

NASDAQ Small Cap market has lower listing requirements


S&P 500 Index since 1960

0

400

800

1200

1600

1960 1965 1970 1975 1980 1985 1990 1995 2000

SP500E

S & P 500 Index (1943-1945-100)


Derivative Markets

Listed options beginning in 1973 (Chicago Board Options Exchange or CBOE)

Index futures and options in 1982 (Chicago and elsewhere)

Portfolio insurance Transactions costs of equity risk exposure Market integration


1987

Stock market crash or Market Break of 1987

Brady Commission and analyses of relation between stock, options, and futures markets– Margin differences– Trading halts and price or index differences– Regulatory turf wars (SEC, CFTC)

Circuit breakers and other remedies


Raising Equity

Small firms finance studied in Berger and Udell (1998) for U.S.– Small firms and economic growth– Small firms and developing economies

Angel capital and small-firm finance Venture capital funds Debt and equity in small business finance Initial public offerings (IPOs)


Current Issues in Equity Trading

Global capital market integration– Concern is market fragmentation

Three conflicting trends in equity trading– Consolidation of global trading in largest

markets (e.g. American Depository Receipts or ADRs and Brazilian market)

– Affiliations and mergers between exchanges (Singapore and NASDAQ, Europe)

– Electronic Communication Networks (ECN) and Internet-based trading


Trading Volume

For every buyer, there is a seller– Buyers and sellers can order broker to buy/sell

at market or place a stop order Trading in stocks comes from buy/sell

orders from categories defined– Institutional traders and block traders– Individual traders– Information and noise traders– Arbitrage traders, speculators, short-sellers


Returns on Stocks and Bonds

Relevant return for investors is holding-period returns on their investments

Most widely used source of return data is annual update of Ibbotson and Sinquefield’s Stocks, Bonds, Bills, and Inflation: 2000 Yearbook

Annual returns based on monthly data from 1926 starting point for analyzing different classes of assets’ returns


Total Annual Returns, 1926-2002

Return (%) Standard Deviation (%)Common Stocks 12.2 20.5Small-Company Stocks 16.9 33.2Long-Term Corporate Bonds 6.2 8.7Long-Term Government Bonds 5.8 9.4U.S. Treasury Bills 3.8 3.2Inflation 3.1 4.4

Ross, Westerfield, Jaffe, Corporate Finance 7th Ed. (2005)


S&P P-E Ratio 1960 to 2004

Source: Haver Data Base, Econviews

0

20

40

60

80

100

120

10 20 30 40

Series: SPE5COMMSample 1960M01 2004M12Observations 540

Mean 17.40604Median 16.99500Maximum 46.50000Minimum 6.680000Std. Dev. 7.177996Skewness 1.162655Kurtosis 5.166622

Jarque-Bera 227.2796Probability 0.000000

S&P 500 Composite P-E Ratio 1960 to 2004


What Explained U.S. Market? New era explanation

– Growth steadier and higher» Global economic expansion and market economies

» Spread of equity markets and market integration

– Uncertainty reduced– Demand for equities increased

» Baby boomers

» Global spread of capital markets

Risk premium reduced to level around 4%


Alternative: Speculative Bubble History is filled with periods of temporary stock

market valuation– Classic Tulip Mania and South Seas bubbles– Japanese bubble

Recent changes foster potential for naïve investors to make errors– Internet trading– Shift to self-directed retirement savings

Historical relations will return (but when?)


Recent Market Performance

Stock indices down from recent highs Rates of return very high (over 20% per

year) until 2000, then became negative Adjustment to lower risk premium could

explain change in P-Es and very high returns

Implications are lower returns in future– See numerical example


Example of Adjustment Year r g payout P-E Index Return Earnings1990 0.1300 0.08 0.5 10.0 400 - 40.001991 0.1275 0.08 0.5 10.5 455 18.7% 43.201992 0.1250 0.08 0.5 11.1 518 18.8% 46.661993 0.1225 0.08 0.5 11.8 593 18.9% 50.391994 0.1200 0.08 0.5 12.5 680 19.0% 54.421995 0.1175 0.08 0.5 13.3 784 19.2% 58.771996 0.1150 0.08 0.5 14.3 907 19.5% 63.471997 0.1125 0.08 0.5 15.4 1055 19.8% 68.551998 0.1100 0.08 0.5 16.7 1234 20.3% 74.041999 0.1075 0.08 0.5 18.2 1454 20.8% 79.962000 0.1050 0.08 0.5 20.0 1727 21.6% 86.362001 0.1025 0.08 0.5 22.2 2073 22.5% 93.272002 0.1000 0.08 0.5 25.0 2518 23.8% 100.732003 0.1000 0.08 0.5 25.0 2720 10.0% 108.782004 0.1000 0.08 0.5 25.0 2937 10.0% 117.492005 0.1000 0.08 0.5 25.0 3172 10.0% 126.89


Global Equity Markets 1999

Country

Number of

Firms

Market Capitalization

(Billions)

Percent of

Global Total U.S.A. 7,561 $16,635 47.06% Japan 2,470 4,547 12.86%

United Kingdom 1,945 2,933 8.30% France 968 1,475 4.17%

Germany 933 1,432 4.05% South Korea 725 309 0.87%

Non-OECD

China 950 331 0.94% Taiwan 462 376 1.06%

World Total 35,044 35,346 100.00%

Source: IMF Working Paper 00/216


Emerging Market Performance

Country

Price Index (1988=100)

Year-to-Date Total Return (%)

China 44.89 -4.51

South Korea 51.09 -7.29

Taiwan 117.96 -15.95

Asia 106.96 N/a

East Europe 71.32 N/a

Latin America 531.87 N/a

Composite 198.21 -21.3Source:IFC S&P/IFCI Index, 3/28/2002 (column 2) and WSJ, 11/15/2002 (column 3)


Small-Firm Public Equity Market In addition to main exchanges, many

countries have second board markets (SBMs) to list smaller firms (start-ups, technology firms, etc.)

In U.S., Nasdaq small-cap market, Germany Neuer Markt, Japan MOTHERS

In Asia, also have SBMs in many countries– Sometimes a subunit of main exchange– Can be separate exchange with own trading

mechanisms


Private/Public Equity Markets

Venture capital is important source of start-up and restructuring firm financing– Provides many services, including advice on

strategy, staffing, and financing– Often have board roles

Venture capitalists might exploit entrepreneurs if they did not have the goal of going public


Issues in Global Markets

Integration of capital markets– How much or how little do events in one

market reflect events in other markets– Expected real returns across markets

Benefits of diversification– Risk reduction through correlations of returns– How to choose portfolio allocations

Risks of international investing


Recent Findings

Importance of global effects has increased in the “new economy” of the 1990’s

Emerging country specific risk has increased dramatically since the crises of the 1990’s while developed-country specific risk has declined

Industry factors, especially technology, probably explain higher correlations


Global Financial Management Investment in assets

– Find highest NPV or highest return projects on a risk-adjusted basis

– Cash flows measured in purchasing power of owners (maximize shareholders’ wealth!)

Financing – Minimize cost of funds on a risk-adjusted basis

International finance: analysis of currency and political risks that are unique to foreign operations


Currency and Political Risk Currency risk is variability in cash returns

due to variations in exchange rates– For important currencies can be hedged in

financial markets– Often can be hedged on the balance sheet by

operating and financing policies – Some currencies cannot be hedged: what kind

of risk is currency risk (systematic, liquidity, etc.)?


Foreign Exchange Markets

Largest market in the world, with estimated $1.5 trillion daily turnover

Biggest concentration in is London (32%), United States (18%), Japan (8%)

Most London trading by U.S. firms there 2,000 dealers Dollar involved in 87% trades OTC market is over 90% activity, including

derivatives (e.g. options, swaps)


International Capital Flows

Where are highest real returns to be found in the world today?– Emerging market economies (educated, hard-

working labor, low capital stocks)– The United States? (capital inflow, new

economy, benign business environment)– Europe? (opening to East, Euro, restructuring)– Latin America?


Determinants of Capital Flows Take advantage of higher returns

– Japanese investments in Asian neighbors– OPEC investments in diversified economies

Benefits from diversification– Pension funds and other institutional flows

Arbitrage risk-return differentials– Temporary differentials that are expected to go

away, as from political threats that can be managed by diversification


Issues in International Investing

Taxes and/or restrictions of payment of dividends or proceeds of sale

Currency related issues– Ability to hedge and/or convert cash flows– Costs of currency hedging and/or conversion– Currency risk due to economic fundamentals

(devaluation/revaluation) Liquidity and transaction costs


Conclusions

High returns in U.S. market in recent past were unlikely to continue but interpretation not easy

Diversification is always rational Some foreign markets have languished in

recent years (but not all, e.g. U.K.) Economic systems contain self-corrective

forces but adjustments may take all long time


Next Class – Nov. 30, 2005

Read Chapters 23 and 24 Remember due date on group project is in

two weeks, November 30 Final is scheduled on December 7, 7:00 to

9:00pm Review objectives and slides and determine

whether you would find review session useful

Documents

J. K. Dietrich - FBE 524 - Fall, 2005 Fixed Income Market (2): Corporate Debt and Equity Week 14 – November 23, 2005