William F. Maxwell

The Wealth Effects of Repurchases on Bondholders

Prior research has documented positive abnormal stock returns around the announcements of repurchase programs; several explanations of these returns have been suggested, including signaling, free cash flow, and wealth redistributions. This study analyzes abnormal stock, bond, and firm returns around repurchase announcements to examine these hypotheses. We find evidence consistent with both signaling and wealth redistribution. The loss to bondholders is a function of the size of the repurchase, and the risk of the firms debt. We also find that bond ratings are twice as likely to be downgraded as upgraded after the announcement of the repurchase program.

Refinancing Risk and Cash Holdings

Although a firm’s use of shorter-term debt can potentially help it to reduce agency costs of debt and align managers’ interests with those of shareholders, the use of this type of debt increases the firm’s refinancing risk. We hypothesize that firms with debt that has a shorter maturity hold larger cash reserves to reduce important costs they could incur if they have difficulty refinancing their debt. Using a simultaneous equations framework that accounts for the joint determination of cash holdings and debt maturity, we find that firms that shorten (lengthen) the maturity of their debt increase (decrease) their cash holdings. Additionally, we document that U.S. firms have markedly shortened the maturity of their debt over the 1980-2008 period and that this can explain a large fraction of the increase in the cash holdings of these firms over this period. We also show that the market value of a dollar of cash holdings is higher for firms whose debt has a shorter maturity. Further, the inverse associations between the maturity of a firm’s debt with the level and market value of its cash holdings are more pronounced during periods when credit market conditions are tighter and refinancing risk is consequently higher. Finally, we show that larger cash holdings help to mitigate underinvestment problems resulting from refinancing risk. Overall, our findings suggest that refinancing risk is a key determinant of corporate cash holdings. * We thank Malcolm Baker, Travis Box, Murillo Campello, Amar Gande, Kathy Kahle, Swaminathan Kalpathy, and seminar participants at McGill University, Texas Tech University, Virginia Tech University, the University of Arizona, and the 2011 University of Innsbruck – Financial Markets and Risk conference for helpful comments. We also thank Douglas Fairhurst for excellent research assistance.

Do Spin-Offs Expropriate Wealth from Bondholders?

A wealth transfer from bondholders to stockholders is one of several hypotheses used to explain stockholder gains on the announcement of a spin-off. However, previous empirical research has not found systematic evidence supporting the wealth expropriation hypothesis. Using a larger sample with comprehensive bond data, we find evidence consistent with wealth expropriation. Bondholders, on average, suffer a significant negative abnormal return during the month of the spin-off announcement. However, even accounting for the loss to the bondholders, the aggregate value of the publicly traded debt and equity increases on a spin-off announcement, suggesting that the wealth expropriation hypothesis is not a complete explanation of the stockholder gains. In explaining the magnitude of the losses to bondholders, we find they are a function of the loss in collateral in the spun-off subsidiary and the level of financial risk of the parent firm. Consistent with a loss to bondholders, firms are more likely to have their credit rating downgraded than upgraded after a spin-off. Additionally, consistent with the wealth transfer hypothesis, losses to bondholders tend to be more severe, the larger the gains to shareholders.

A Reexamination of the Tradeoff between the Future Benefit and Riskiness of R&D Increases

Many previous studies document a positive relation between research and development (R&D) and equity value. Though R&D can increase equity value by increasing firm value, it can also increase equity value at the expense of bondholder wealth through an increase in firm risk because equity is analogous to a call option on the underlying firm value. Shi (2003) tests this hypothesis by examining the relation between a firms R&D intensity and its bond ratings and risk premiums at issuance. His results show that the net effect of R&D is negative for bondholders. We reexamine Shis findings and in so doing make three contributions to the literature. First, we find that Shis results are sensitive to the method of measuring R&D intensity. When we use what we argue is a better measure of R&D intensity, we find that the net effect of R&D is positive for bondholders. Second, when we use tests that Shi recognizes are even better than the ones that he uses, we find even stronger evidence of the positive effect of R&D on bondholders. Third, we examine cross-sectional differences in the effect of R&D on debtholders. Consistent with our main finding, we document a negative relation between R&D increases and default risk. The default risk reduction is also more pronounced for firms with higher initial default scores (where the debtholders have more to gain from an R&D increase) and for firms with more bank debt (where the debtholders have greater covenant protection from the possible detriments associated with R&D increases).

Modeling correlated market and credit risk in fixed income portfolios

Abstract Current risk assessment methodologies separate the analysis of market and credit risk and thus misestimate security and portfolio risk levels. We propose a new approach that relates financial market volatility to firm specific credit risk and integrates interest rate, interest rate spread, and foreign exchange rate risk into one overall fixed income portfolio risk assessment. Accounting for the correlation between these significant risk factors as well as portfolio diversification results in improved risk measurement and management. The methodology is shown to produce reasonable credit transition probabilities, prices for bonds with credit risk, and portfolio value-at-risk measures.

Factors affecting the yields on noninvestment grade bond indices: a cointegration analysis

Abstract This study examines the long- and short-run dynamics of the yields on noninvestment grade indices. Utilizing cointegration techniques, the traditional yield spread model is found to be inadequate. A revised model finds a long-run relationship between noninvestment grade yields, Treasury securities, and default rates. Error correction models are formulated to model the short-run dynamics of different segments of the market. These models include a long-run equilibrium (between yields, default rates, and Treasuries), mutual fund flows, minor bond ratings, debt subordination measures, a stock index, and a January effect. Segmentation in the noninvestment grade market is also demonstrated.

Trading Activity and Transaction Costs in Structured Credit Products

After conducting the first study of secondary trading in structured credit products, the authors report that the majority of products did not trade even once during the 21-month sample. Execution costs averaged 24 bps when trades occurred and were considerably higher for products with a greater proportion of retail-size trades. The authors estimate that the introduction of public trade reporting would decrease trading costs in retail-oriented products by 5–7 bps. Structured credit products (SCPs), including asset-backed securities (ABSs) and mortgage-backed securities (MBSs), compose one of the largest (comparable in size to the US Treasury security market) but least studied segments of the financial services industry. SCPs are complex instruments that include the payment obligations of numerous borrowers, contain multiple tranches that differ in terms of payment priority in case of default, and have sizes that can change randomly as underlying loans are repaid. Uncertainty regarding SCP valuation played a role in the recent financial crisis, owing in part to the fact that secondary trades for SCPs occurred in an opaque dealer market without public quotes or trade reports. Since May 2011, FINRA has required broker/dealers to report transaction prices and quantities for SCP trades to the TRACE (Trade Reporting and Compliance Engine) system. However, FINRA does not yet disseminate data for most SCP transactions to the public. Effective 5 November 2012, the U.S. SEC approved the public dissemination of transaction prices in a subset of SCPs (specifically, in “to-be-announced” securities). FINRA has recently proposed that trade prices of SCPs, including MBSs and ABSs, be disseminated to the public. For investors as well as regulators, the key difficulty in an opaque market lies in establishing the prevailing market price. Investors cannot compare their own execution prices with those observed for other transactions. Even institutional investors have to invest significant time and effort to obtain market information, either via ‘‘indicative’’ quotes obtained through messaging systems or by telephone calls to dealers. Increased transparency has the potential to reduce dealer markups, provide information on the fair price of securities, and improve the ability to control and evaluate trade execution costs. In this study, we examined the accumulated FINRA data to provide what we believe is the first comprehensive description of this important but little-studied market. The data include all secondary market transactions for the universe of US SCPs from 16 May 2011 to 31 January 2013. We report on trading activity by subtypes of SCPs, the determinants of secondary market trading, and estimates of transaction costs in each type of SCP. Finally, focusing on segments of the corporate bond market that are comparable to segments of the SCP markets in terms of key characteristics, we present estimates of the potential effects of implementing transaction dissemination in these markets. Notably, less than 20% of the SCP universe traded at all during the 21-month sample period. One-way trade execution costs for SCPs averaged about 24 bps. However, trade execution costs varied substantially across SCP categories, from 92 bps for CBOs to just 1 bp for TBA securities. We show that trading costs depend in particular on what we term the product’s “customer profile,” which depends on issue size and the proportion of retail to institutional-size trades. Subproducts with an institutional profile tend to have lower costs. The highest average trading costs are observed for agency CMOs (74 bps) and CBOs (92 bps), each of which has a low (22% or less) proportion of large trades. The lowest average trading cost estimates are observed for TBA securities (1 bp), CMBSs (12 bps), and ABSs secured by auto loans and equipment (7 bps), each of which has a substantial (54% or greater) percentage of large trades. By matching SCP subtypes with corporate bonds that are comparable in terms of customer profile, we present rough estimates of the potential impact of introducing price transparency for the SCP markets. Our analysis indicates that price transparency is likely to be associated with substantial decreases of 5–7 bps in one-way trading costs for MBSs, agency CMOs, and CBO securities, as well as securities in the subgroups TRAN and WHLN. We anticipate smaller trading cost reductions of about 2 bps for private label CMOs. In contrast, we anticipate little or no change in trading costs for CMBSs and SBA securities, as well as ABSY issues and CDOs. Broadly speaking, this analysis indicates that trading cost reductions are most likely to be observed for SCPs with a retail clientele, whereas transaction dissemination is less likely to be relevant for those products with an institutional clientele, which already carry lower trading costs.After conducting the first study of secondary trading in structured credit products, the authors report that the majority of products did not trade even once during the 21-month sample. Execution costs averaged 24 bps when trades occurred and were considerably higher for products with a greater proportion of retail-size trades. The authors estimate that the introduction of public trade reporting would decrease trading costs in retail-oriented products by 5–7 bps.

Modeling the yields on noninvestment grade bond indexes: Credit risk and macroeconomic factors

Abstract To accurately price credit derivatives, it is necessary to understand the underlying factors that determine credit spreads and the influence that external shocks can have on required yields. We model the factors that influence the yield on the most volatile segment of the corporate bond market, noninvestment grade bonds. A long-run equilibrium is found between the yield on BB- and B-rated bonds and Treasury yields, Moodys default rate, and the leading economic indicator. In the short run, changes in Treasury yields, Moodys default rates, and mutual fund flow continue to affect the movements in noninvestment yields. We also find that the resulting error correction models are useful in forecasting the yields. External shocks have a greater effect on the more volatile B-rated bonds. We find that the Iraq invasion of Kuwait, the Russian and Asian financial crises, and Long-Term Capital Management collapse all have influence on noninvestment grade yields. Evidence is also found suggesting a significant flight to quality for BB- and B-rated bonds during the Russian financial crisis.

Contingent Claims Analysis Applied in Credit Risk Modeling

A fundamental in credit risk analysis is estimation of the probability that fixed-income securities will migrate to different bond rating categories. Unlike historical transition probabilities, several contingent claims credit risk methodologies simulate the value of a firms assets and/or debt ratio to create bond rating probability distributions. This study tests the validity of using empirically calculated debt ratios to assign bond ratings. The empirical tests provide evidence supporting the use of such methodologies, with some caveats. Debt ratios are industry-specific and time-dependent, so care must be taken in estimating model parameters from historical relationships.

Capital Commitment and Illiquidity in Corporate Bonds

We study trading costs and dealer behavior in U.S. corporate bond markets from 2006 to 2016. Despite a temporary spike during the financial crisis, average trade execution costs have not increased notably over time. However, dealer capital commitment, turnover, block trade frequency, and average trade size decreased during the financial crisis and thereafter. These declines are attributable to bank‐affiliated dealers, as nonbank dealers have increased their market commitment. Our evidence indicates that liquidity provision in the corporate bond markets is evolving away from the commitment of bank‐affiliated dealer capital to absorb customer imbalances, and that postcrisis banking regulations likely contribute.