Fixed Income Market (2): Corporate Debt and Equity

1
Fixed Income Market (2) Corporate Debt and Equity

• Week 14 November 23, 2005

2
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

3
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

4
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

5
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

6
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

7
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

8
Major Sources of Funds
Source Flow of Funds
9
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

10
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
11
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

12
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

13
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

14
Investors in Corporate Debt
Total includes non-financial and financial
corporate business bonds Source Flow
of Funds
15
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

16
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 firms assets

17
Risk-Free Bond and Asset Put
F
F
Risk-Free Bond
Payoff
Risky Bond
Asset Put
0
0
Asset Value
Asset Value
F
F
18
Bonds and Options (2)

• 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

19
Convertible Bonds
F
Convertible Risky Bond
0
Asset Value
F
20
Bonds and Options (3)

• 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

21
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

22
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

23
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

24
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)

25
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

26
Capital Effect on 5 billion CLO
Assumptions Loan portfolio yield Bank funding costs CLO execution spread Assumptions Loan portfolio yield Bank funding costs CLO execution spread
Assumptions Loan portfolio yield Bank funding costs CLO execution spread Assumptions Loan portfolio yield Bank funding costs CLO execution spread LIBOR 75 basis points LIBOR 75 basis points
Assumptions Loan portfolio yield Bank funding costs CLO execution spread Assumptions Loan portfolio yield Bank funding costs CLO execution spread LIBOR 12.5 basis points LIBOR 12.5 basis points
Assumptions Loan portfolio yield Bank funding costs CLO execution spread Assumptions Loan portfolio yield Bank funding costs CLO execution spread LIBOR 19 basis points LIBOR 19 basis points
Before CLO After CLO Before CLO After CLO
Net spread earned 43,750,000 (L75-L12.5) 43,750,000 (L75-L12.5) 28,000,000 (L75-L19)
Risk Based Capital 400,000,000 (5 bi. x 8) 400,000,000 (5 bi. x 8) 100,000,000 (100 reserve)
Return on capital 10.9 10.9 28.0
27
Structure of CLO
Issuing Trust
Unaffiliated Institution Investor
Special Purpose Vehicle (SPV)
Bank Lender
Unaffiliated Institution Investor
Unaffiliated Institution Investor
Business Borrowers
Servicer (Bank)
28
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

29
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
• SP 500 industrials, other subgroups
• NASDAQ
• Other Indices Russell indices, Wilshire 5000,
  Morgan Stanley Capital International (MSCI)

30
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

31
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

32
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

33
U.S. Markets prior to 1975
NYSE
CSE
MWSE
ASE
PSE
BSE
34
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

35
U.S. Markets after 1975
ITS
NYSE
CSE
MWSE
Composite Tape
ASE
BSE
PSE
36
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

37
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

38
SP 500 Index since 1960
39
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

40
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

41
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)

42
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

43
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

44
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 Sinquefields Stocks,
  Bonds, Bills, and Inflation 2000 Yearbook
• Annual returns based on monthly data from 1926
  starting point for analyzing different classes of
  assets returns

45
Total Annual Returns, 1926-2002
Ross, Westerfield, Jaffe, Corporate Finance 7th
Ed. (2005)
46
SP P-E Ratio 1960 to 2004
Source Haver Data Base, Econviews
47
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

48
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?)

49
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

50
Example of Adjustment
51
Global Equity Markets 1999
Source IMF Working Paper 00/216
52
Emerging Market Performance
Country Price Index (1988100) 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 -21.3
SourceIFC SP/IFCI Index, 3/28/2002 (column 2)
and WSJ, 11/15/2002 (column 3)
53
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

54
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

55
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

56
Recent Findings

• Importance of global effects has increased in the
  new economy of the 1990s
• Emerging country specific risk has increased
  dramatically since the crises of the 1990s while
  developed-country specific risk has declined
• Industry factors, especially technology, probably
  explain higher correlations

57
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

58
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.)?

59
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)

60
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?

61
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

62
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

63
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

64
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, 700 to 900pm
• Review objectives and slides and determine
  whether you would find review session useful