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Fixed Income Market (2): Corporate Debt and Equity

Fixed Income Market (2): Corporate Debt and Equity. Week 14 – November 23, 2005. Corporate Financing.

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Fixed Income Market (2): Corporate Debt and Equity

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  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 ordertheory 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 firm’s assets

  17. Risk-Free Bond and Asset Put F F Risk-Free Bond Payoff Risky Bond Asset Put 0 0 F Asset Value F Asset Value

  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 F Asset Value

  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

  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 • S&P 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 • Specialistshave obligations and privileges • Floor tradersbuy and sell for own account • Commission andfloor brokersexecute orders • Brokersexecute 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. S&P 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 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

  45. Total Annual Returns, 1926-2002 Ross, Westerfield, Jaffe, Corporate Finance 7th Ed. (2005)

  46. S&P 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

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