J. K. Dietrich - FBE 524 - Fall, 2005 Fixed Income Market (2): Corporate Debt and Equity Week 14 –...
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Transcript of J. K. Dietrich - FBE 524 - Fall, 2005 Fixed Income Market (2): Corporate Debt and Equity Week 14 –...
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
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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%
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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%
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
Risk-Free Bond and Asset Put
Asset Value0
Pay
off
Asset Value0
F
F
Risk-Free Bond
Asset Put
F
F
Risky Bond
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
Convertible Bonds
Asset Value0
F
F
Convertible Risky Bond
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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%
J. K. Dietrich - FBE 524 - Fall, 2005
Structure of CLO
Issuing Trust
Special Purpose
Vehicle (SPV)
Servicer (Bank)
UnaffiliatedInstitutionInvestor
UnaffiliatedInstitutionInvestor
UnaffiliatedInstitutionInvestor
Bank Lender
Business Borrowers
J. K. Dietrich - FBE 524 - Fall, 2005
“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
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
U.S. Markets prior to 1975
NYSE
MWSE
ASE
CSE
BSE PSE
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
U.S. Markets after 1975
NYSE
MWSE
ASE
CSE
BSE PSE
Composite Tape
ITS
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 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
J. K. Dietrich - FBE 524 - Fall, 2005
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%
J. K. Dietrich - FBE 524 - Fall, 2005
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?)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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.)?
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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?
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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