Randall Johnston Pozdena

English

Research Papers in Economics

FRBSF WEEKLY LETTER
April 10, 1987
Junk Bonds: Why Now?
One of the most visible developments in finance
markets in recent years has been the rapid
growth in the issuance of low~rated bonds to
finance corporate activity. The quarterly volume
of new debt issues with a Moody's rating below
Baa (referred to variously as "noninvestment
grade", "high yield", or "junk" bonds)
amounted to only $380 million as recently as
the first quarter of 1982, but had grown to $11
billioh by the second quarter of 1986. Presently,
junk bond financing represents 20 to 30 percent
of all corporate debt issuance.
The increasing use of junk bonds is the subject
of vigorous public and policymaker debate for a
number of reasons. Some observers are con-
cerned because some of these high yield - and
high risk - bonds are held in the portfolios of
thrift institutions, life insurance companies, and
pension funds where they may put the income
of investors at risk. There is also concern that
junk bonds facilitate corporate takeovers, an
activity that some consider inherently undesir-
able. Finally, there is the concern that the prom-
ised yields of junk bonds will fail to materialize
and that the defaults will reverberate through the
capital markets.
By understanding the reasons for the recent pop-
ularity of junk bonds, it should be possible to
put these concerns in perspective. This Letter
reports on an examination currently underway at
this Bank of the behavior of the junk bond mar-
ket. We find that recent changes in the structure
of personal and corporate tax policy may be an
important stimulant to debt financing in general
and the junk bond market in particular.
Conventional explanations
Although numerous explanations have been
offered for the recent surge in junk bond issu-
ance, most of these explanations do not survive
close inspection. One explanation, for example,
is that investment banks and brokerage firms
recently discovered an "untapped" investor
interest in high yield, high risk debt. It is true
that investment banks have been the vehicle
through which junk bond debt has been issued,
and that they have facilitated trading by main-
taining markets in junk bonds. However, since it
is unlikely that long latent investor demand
would go unexploited, this explanation does not
account for why the market has grown so
rapidly in recent years.
A second conventional explanation is that
improvements in information technology now
make it economical to evaluate investments in
smaller and high-risk firms. Combined with the
growth of investment portfolios of sufficient
scale to permit diversified holdings of low-rated
debt, these improvements are seen as making
the issuance of junk bonds more feasible.
Although recent improvements in technology
may well be contributing to the development of
the junk bond market, they cannot offer a com-
plete explanation since junk bonds also were
common in the first four decades of this century.
Indeed, noninvestment grade debt averaged
about 35 percent of all debt issued between
191 0 and 1947.
A third explanation for the recent jump in junk
bond issuance is that investor preferences have
changed in recent years and, in particular, that
investors now are less adverse to holding corpo-
rate securities. This argument is difficult to dis-
prove since it is impossible to observe investor
preferences directly. But it leaves unexplained
why a similar surge in equity issuance has not
occurred. Certain propositions in finance theory
argue that a firm's debt and equity issues offer
the same risk-return opportunities on the margin
and equity certainty is a liquid security. In fact,
net new equity issuance in recent years has
actually turned sharply negative at the same
time that debt financing generally and junk bond
financing in particular have surged (Chart 1).FRBSF
Debt vs. equity in the firm
There is an alternative explanation for the
resurgence of junk debt financing that also is
consistent with the dramatic decline of net new
equity issuance and increased debt issuance
generally. This explanation draws on the theory
of the capital structure ofthe firm ~ that is, the
amount of debt versus equity used by a firm to
finance its assets.
According to this theory, firms select a capital
structure that maximizes their value (the value of
their equity). Economists Modigliani and Miller
have shown that, in the absence of taxes, bank-
ruptcy costs, and other sources of distortion, the
value of the firm in theory is independent of its
capital structure. In the real world, however, dis-
tortions exist and have been postulated to be the
source of a firm's preference for one capital
structure over another.
Taxes are particularly likely to influence capital
structure. Both corporate and individual income
is taxed in our economy. A firm is taxed on its
gross income minus (among other things) inter-
est payments on its debt. Since interest expense
reduces corporate tax liability, it provides a "tax
shield" for the corporation's income, creating a
bias in favor of debt financing, everything else
being equal. These interest payments are,
however, income to individuals in the economy
and are taxed at the personal income tax rate.
If the corporation were to choose equity financ-
ing instead, it would forego the tax shield bene-
fits of debt, but individual equity owners would
enjoy income in the form of capital gains. Capi-
tal gains enjoy preferential tax treatment since
personal tax obligations on such gains can be
delayed until shares in the firm are sold and,
untihecently, Were taxed at a lower rate than
other income. This preferential treatment creates
an offsetting bias in favor of equity finance.
Corporate vs personal income tax rates
Whether a firm chooses a debt- or equity-heavy
capital structure, therefore, may depend upon
the relationship between corporate and personal
tax structures. If the corporate tax rate were low
relative to the personal tax rate, the value to the
corporation of the "tax shield" offered by debt
would be low, whereas the benefits to individ-
uals of avoiding the personal tax liability associ"
ated with holding debt would be high. In such a
case, the market (that is, the combined effect of
firms and investors) would tend to prefer equity
finance. If the reverse (corporate tax rates were
high relative to personal tax rates) were true,
there would be a tendency toward debt finance.
This simple view of the effect oftaxes on corpo-
rate financial structure implies that firms will be
either all equity or all debt financed depending
upon relative corporate and personal tax rates.
In reality, of course, we observe a mixture of
debt and equity in the economy and variations
in financial strategies across firms. Economist
Merton Miller has argued that the existence of
differentpersonal tax rates for different individ-
uals creates "c1ienteles" for both debt and
equity that results in the observed mixture of
debt and equity in the economy.
Another explanation for the mixture of debt and
equity financing is that not all firms can take full
advantage of debt-related tax shields. For exam-
ple, a firm for which tax shields are of no value,
such as one with low current income (as is the
case with start-up firms), would prefer equity
financing regardless of the tax structure. Firms
with high income and sufficient sources of tax
shields not related to debt (such as high
depreciation allowances, which are deductible
from the corporation's income for tax purposes)
also would prefer equity financing. Thus, the
ability to exploit debt-related tax shields and,
hence, the influence of tax policy on financial
structure, varies somewhat across firms. .
Tax policy and risky debt
The observation that high relative corporate tax
rates increase the preference for debt ("high
leverage") financing does not imply directly that
there would be an increase in high risk, "junk"
debt. For firms whose debt is on the borderline
of being noninvestment grade, however,
attempts to increase leverage would generate a
deterioration of their debt rating. Thus, if all
firms simultaneously desire higher leverage,
overall corporate debtmust be more riskyon the
margin. Increases in junk debt issuance therefore
may naturally accompany attempts to increase
overall leverage.A more complex argument that may be used to
relate high-risk debt issuance to tax policy has
been made by economists Eli Talmor, Joseph
Zechner, and others. They point out that in the
u.s. tax code, all payments to debtholders in
excess ofthe market value ofthe debt at issu-
ance are deductible and hence a potential
source of a tax shield. High yield (high risk) debt
by definition is debt whose promised payments
are large relative to the initial market value.
Hence, the greater the firm's leverage and the
riskier the debt, the greater is the valueof the tax
shield of an additional dollar of debt. The riskier
the debt, of course, the greater is the likelihood
of default. It can be shown, however, that on
balance the value of debt as a tax shield still can
increase with the riskiness of the debt.
o
20
10
40
30
-10
$ Billions
1985
Source: FRBSF
1980 1975 1970
Chart 1
The Tax Differential and the Issuance
of Corporate Debt and Equity
*Net Dollar Flow
o
-5
Tax Differential
..... ~;;;"'-~i""
~ •.J
Corporate Bond Issuance., ~ .'
.::::.::::.::::.c.~>::.-,r.:.~'.:::.:.~.::::' ~.!~. :'~{
-15 Equity I:s~~~ce'\ i
~ i
V··fV:" -20
-10
Percent
-25 L...L--'--.L..J=--'-'-J.--'--..L..J.--L...I-==-..L..J.--L...I-L-I -30
1965
-20
Chart 2A
The Tax Differential and Junk Bonds, 1900-47
Percent $ Millions
Source: Hickman, FRBSF
Empirical evidence and conclusions
Thus, if tax policy makes debt-related tax shields
generally attractive, it also stimulates the issu-
ance of risky debt. This proposition is demon-
strated in the historical relationship between
financing activity and the difference between the
highest corporate and personal marginal tax
rates (the "tax differential"). As Charts 2A and B
illustrate, the volume of junk bond issuance
does indeed appear to have risen and fallen with
the tax differential, at least for the two periods
for which junk bond data are available. Chart 1
shows that the tax differential also appears to be
related to the very sharp decline in the net issu-
ance of equity (and the increase in debt issu-
ance) that has occurred in the last five years or
so.
250
o
750
500
1000
1250
1940 1945 1930 1920 1910
10
01----' ....
-10 • j i Tax Differential
-20 ..... \
-30 •
-40 ~\.\
-50 ".J
-60
-70 L-----l_---L_---L_..l.-_l----l._---L_-'-_.l.....J
1900
Chart 2B
The Tax Differential and Junk Bonds, 1975-86
Percent $ Billions
o r
1975 1980 1985 1986
Source: FRBSF, IDO Inc.
12.5
Although conventional explanations also.may be
useful in explaining the debt finance "boom" of
recent years, the explanation offered here based
on the theory of the capital structure of the firm
is less ad hoc. In addition, it forecasts a par-
ticularly interesting implication of the tax reform
embodied in the 1986 Tax Act. By 1988, the top
marginal personal tax rate will beonly 28 per-
cent versus 34 percent for corporations - a tax
differential of +6 percent. This will be the first
positive tax differential since 1908 and the
largest in the 80-year historyof incometaxation
in the U..5. Our analysissuggests that this dif-
ferential could be a powerful stimulus to con-
tinued debt issuance generally and the junk
bond market in particular.
Randall Johnston Pozdena
Opinionsexpressed in this newsletterdo not necessarily reflect theviews of themanagementofthe Federal Reserve BankofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6U!4S0m 4o~n U060JO OpOJl0U
040PI !!omoH O!UJoJlIO) ouoz!J~ o~sol~
O)SI)UOJ:::I UOS
JO ~U08
al\Jasa~ IOJapa:::l
~uaw~Jodaa LpJOaSa~
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
3/18/87
Change
from
3/11187
Change from 3/19/86
Dollar Percent?
Loans, Leases and Investments1 2 204,474 792 471 0.2
Loans and Leases1 6 183,877 1,111 - 1,338 - 0.7
Commercial and Industrial 54,032 439 246 0.4
Real estate 67,879 - 29 1,512 2.2
Loans to Individuals 37,228 75 - 3,584 - 8.7
Leases 5,441 - 19 - 213 - 3.7
U. S. Treasury and Agency Securities2 13,486 - 335 2,715 25.2
OtherSecurities2 7,112 17 - 905 - 11.2
Total Deposits 207,020 - 1,378 5,545 2.7
Demand Deposits 51,574 - 1,247 3,842 8.0
Demand Deposits Adjusted3 34,835 -13,930 2,332 7.1
OtherTransaction Balances4 19,439 - 122 4,110 26.8
Total Non-Transaction Balances6 136,007 - 8 - 2,408 - 1.7
MoneyMarket Deposit
Accounts-Total 46,776 58 957 2.0
Time Deposits in Amounts of
$100,000or more 32,495 - 22 - 5,761 - 15.0
Other Liabilities for Borrowed MoneyS 24,488 1,048 - 2,848 - 10.4
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)jDeficiency(-)
Borrowings
Netfree reserves (+)jNet borrowed(-)
Period ended
3/9/87
91
18
72
Period ended
2/23/87
45
7
38
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes u.s. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
5 Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

Junk bonds: why now?

http://www.frbsf.org/publications/economics/letter/1987/el87-15.pdf

Junk bonds: why now?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics