Steven V. Mann

Timing of Convertible Debt Issues

Abstract The popularity of convertible debt as a financing vehicle waxes and wanes. In this article, we investigate whether the timing of convertible debt issues can be explained by three reported reasons for its use as a financing vehicle. Specifically, we reexamine the long-standing beliefs that convertibles are used as “debt sweeteners” and there are “hot issue” markets for these securities. In addition, we examine whether convertibles help diminish the agency conflict between bondholders and stockholders as suggested by Brennan and Schwartz (1988) . Our empirical results suggest that: (1) corporate managers issue convertible debt as debt sweeteners and (2) more convertible debt is issued in hot markets.

The Relative Performance of Yield Curve Strategies

Columbia (SC 29208). uration is a useful metric for assessing a bond portfolio’s sensitivity to a parallel shift in the yield curve. When the yield curve shift is not parallel, however, two bond portfolios with the same duration may not experienlce the same return performance. To evaluate differences in expected performance across portfolios, it is therefore necessary to quanti

An Overlooked Coupon Effect in Treasury Futures Contracts

the price impact due to changes in shape, as opposed to merely shift, of the yield cume. Litterman and Scheinkman [1991] suggest that changes in shape are due mostly to parallel shf t s , changes in slope (i.e., twist), and changes in curvature (i.e., humpedness or butterfly changes). Jones [1991] and Willner [1996] inhcate that these three types of changes in the yield curve’s shape (level, slope, and curvature) are not independent, so correlations among them must be considered when estimating the bond portfolio’s expected performance. Bond portfolio managers pursuing active strategies must therefore consider all three yield curve parameters as well as correlations among changes in these parameters. Consider, for example, yield curve strategies that involve structuring a portfolio to exploit expected changes in the yield curve’s shape. Three basic yield curve strategies are: 1) bullet strategies; 2) ladder strategies; and 3) barbell strateg~es (see Fabozzi [1996]). A bullet strategy calls for investing in a bullet portfolio, which is constructed so that maturities of the bonds are concentrated at one particdar point on the yield curve. A ladder portfolio is con-

Riding the Bill Curve

Contracts for futures and other derivatives that allow physical delivery must specify a set of deliverable instruments in order to limit the possibility of squeezes in the cash market. But this invariably leads to one or a small number of them becoming “cheapest to deliver” (CTD). Seemingly minor factors in the contract specs can make a lot of difference to which instrument will be CTD. In this article, Grieves and Mann examine the Chicago Board of Trades practice of computing delivery factors for its Treasury bond and Treasury note contracts by rounding each deliverable bonds maturity down to the nearest quarter of a year. This accelerates the predictable “pull to par” effect for bonds that are selling away from par, and also creates a subtle effect related to the bonds coupon rate. The well-known principle that when market yields are above (below) the coupon rate on the reference bond, currently 6%, long (short) duration bonds will be CTD must be modified to account for the coupon effect when yields are close to 6%.

Convertible Preferred Stock Valuation: Tests of Alternative Models

The authors examine the effectiveness of “riding the bill curve” using a comprehensive sample of U.S. Treasury bills over a recent ten-year period. The results suggest that riding the bill curve consistently enhances returns over a buy-and-hold strategy on average. Although the additional return is associated with higher risk, the reward is sufficient for all but the most risk-averse investors. The riding strategys performance deteriorated substantially during the Federal Reserve tightening cycle of 1994–1995. Riding the bill curve, however, is generally preferable to buying and holding relatively expensive “quarter-end” or “tax” bills.

The search for relative value in bonds

We undertake a comprehensive test of several contingent claim valuation models adapted to callable, convertible preferred stocks employing a sample of 24 issues and over 27,000 daily price observations. To our knowledge, no large-scale tests of these models have been published. The most complete model tested is an extension of the 1970s developments of Ingersoll and of Brennan and Schwartz, allowing for realistic contract features including delayed callability and nonconstant call prices. The mean and the mean absolute pricing errors are approximately −0.18 percent and 5.4 percent, respectively, and this model fits the data substantially better than the simpler alternatives that ignore such features. Thus, the added computational complexity required for the most complete model examined is evidently merited. Moreover, to the extent that the most complete model accurately mirrors reality, the evidence suggests that investors rationally account for many of the complex features imbedded in typical contracts.

Simple Approximation of the Value of Callable Convertible Preferred Stock

Comparing asset swap spreads across bonds is a widely used tool for measuring relative value. This approach leads portfolio managers to increase their risk exposure in ways that are not transparent. Credit default swaps are utilized to demonstrate that viewing wide asset swaps as an indicator of relative value is a mirage. The paper documents the empirical regularities in the term structure of credit spreads and spread volatilities that make this result possible. In addition, we present empirical evidence of the imprint made on corporate bond returns by the widespread use of the asset swaps data.

Utility Maximizing Portfolio Insurance Strategies When Hedgers Consider the Impact of Their Trading on Security Prices

We develop an analytic approximation of a model of callable convertible preferred stock that allows for deferred callability and cash dividends on the issuing firms common stock. Predictions of the analytic approximation and the numerical solution are close, hence we show that the benefit of the method (ease of computation) outweighs the cost (negligible computational error). We also show that model prices predict market price with reasonable accuracy. The model is developed so that it may be solved on a handheld calculator or on a personal computer, making accurate price predictions readily available.

Should Individual Investors Avoid the Stock Market Outside of January

Portfolio insurance strategies can destabilize markets to such an extent that they may be counterproductive. Destabilization results when hedgers take share prices as given and follow exogenously specified price-based trading rules. We recognize that such trading rules may not be utility maximizing and that hedging affects share prices. Accordingly, we develop a portfolio insurance strategy where hedgers consider the impact of their trading on prices and endogenize their trading rule which is obtained by maximizing expected utility. Moreover, our strategy does not require the dissemination of information about the extent of portfolio-insurance based hedging activity in the economy.

Portfolio Insurance Strategies when Hedging Affects Share Prices

Abstract Recent studies suggest that there is no reward for bearing risk outside of January, implying that individuals should invest in common stocks only in January. The purpose of this study is to demonstrate that this conclusion is far too strong given existing empirical evidence. Our results suggest that inferences drawn from the evidence can be altered greatly through small changes in the way the empirical question is addressed. There is sufficient evidence to doubt the conclusion that individuals are not compensated for the risk of participating in the stock market outside of January.