The income bond puzzle

Income bonds should be used more extensively by corporations than they are. Their avoidance apparently arises from a mere accident of economic history–namely, that were first employed in quantity connection with railroad reorganizations, and hence have been associated the start financial weakness poor investment status. But form itself has several practical advantages… Chief among these is deductibility interest paid company's taxable income. sum, are securities appear to all supposed tax advantages debt, without bankruptcy cost disadvantages. Yet, except for brief flurry 1960s, such rarely used. The conventional wisdom attributes this dearth unsavory connotations surround bonds. As an banker once put it me: “They smell death about them.” Perhaps so. obvious retort bit ancient Roman wisdom: pecunia non olet (money no odor). 1980's promise exciting decade American capital markets. Recent descriptions our environment featured problems as shortages, inflation at unprecedented rates, usual amount volatility uncertainty credit It time innovation; deep discount bonds, GNMA pass-through securities, futures options only few new financing instruments now being developed introduced unusually rapid pace. also crisis, which very large publicly-held firms failed or approached brink failure. In environment, important practicing manager familiar full array his disposal. Our intention article draw attention again frequently advocated, but infrequently class corporate security: income bond. Before investigating bond “puzzle,” let's review features hybrid combine straight debt preferred stock. Like contractual obligation issuer; give holder claim on earnings ranks ahead equities, common. At same time, however, represent contingent claim: payable if earned. And, because fact instrument, payments deductible issuer. That payment coupon depends level issuer's reported accounting earnings, is, course, most characteristic distinguishing other instruments. If sufficient available after deduction operating expenses, allowable fixed asset depreciation, prior income, then due must paid. (after various allowed expenses) not cover payments, corporation may pass change ownership structure company. Thus, when omitted, technically default, bondholders obtain additional control over company (except possible future accumulated interest). contrast, omitted fixed-interest bond, considered force into bankruptcy. worth noting, can take many characteristics forms debt. They callable, convertible common stock, subordinated classes securities. contain sinking fund provisions. Also, perhaps important, like provision accumulation missed payments. case dividend both “declared” board directors. consequence, unlike trade “flat,” accrued interest. reorganizations followed panics 1873, 1884, 1893. After period, until depression years 1930's. Interstate Commerce Commission decreed had place well-balanced structures and, one extreme case, required substitution stock income-bond issue. During 1930's companies funded debts cyclical incomes found necessary reduce fixed-income segment their structures; useful purpose, issued public utility industrial firms. Around 1940, ICC relaxed its position allowing marked increase use, mostly railroads undergoing reorganization. dramatic departure decades, number solvent early 1950's. 1955 published Harvard Business Review, Sidney Robbins surveyed use corporations, identified four five them. noted while afford virtually benefits instruments, do present danger “default risk” offer management greater flexibility need most–when down. Other writers argued providing advantage following Robbins' article, another handful floated small issues. fact, president Sheraton Corporation wrote letter editor Review indicating become interested direct result article. (Sheraton ultimately sold $35 million bonds.) addition, publication 1961, Trans World Airlines completed financing. But, characterized Robbins, remained “sparse intermittent.”1 One notable exception general neglect was strategy Gamble-Skogmo. mid-1960's, prominent retail built program around $15 1966, thereafter entered market every year through 1976. By 1976 Gamble-Skogmo $200 outstanding. Indeed, 1974, stockholders. From cases Gamble-Skogmo, TWA, railroads, clear strong advocates practitioners finance. Further, writings observers (see epigraph) evidence finance theorists. Why, then, frequently? There considerable reluctance part bankers, issuers, investors overcome before will extensively. noted, encountered resistance bankers own distribute surely, competitive serious pursuing financing, would willing accommodate widely accepted explanation issue tainted association reorganization bankrupt railroads. Because carry “smell death,” those investors–the argument seems imply–that induced hold demand rates return higher returns justified actual risk holding words, persistently undervalued relative forcing pay abnormally high price capital. Another involves made bondholders. never definitive ruling what establish indeed there remains fear laws changed treated dividends. A third scarcity potential “deadweight costs” computation crucial determining whether receive conflicts between stockholders arise methods. concern that, resolution conflicts, incur substantial legal fees. remainder we examine each proffered solutions puzzle. complicated analysis investigates actually earned holders “too high”–that expected, given Using past experience best guide future, historical risks estimate prospective corporations. subsequent sections, look closely considerations, alleged final section some suggests responds favorably structures. attempting determine high” risk, procedure described below. First, compiled sample 53 whose quotes records fairly long period available. This constituted minimum information reach statistically reliable conclusions. month-end combined calculated monthly portfolio January 1956 December (In Appendix listed name issuing sample, original maturity dates left reason bond.) measuring portfolio, measured risk. specified Capital Asset Pricing Model (the last two articles provide detailed elaboration CAPM) “normal” “expected” rate any security, directly proportional Consequently, portfolio's establishing expected straightforward. stage compared risk-adjusted returns. Any difference called “abnormal” return. truly them,” thus systematically underpriced issue, expect significantly positive abnormal negative, conclude cheap source order make results intelligible probably helpful explain briefly procedures imagine ranging along spectrum (and return), find senior secured lower extreme; equities even riskier, warrants upper extreme. Investors' average fall somewhere extremes. uncertain represented (all else equal) risky randomly selected fixed-interest, high-grade We considerably less stocks. rewarded, average, according bear, riskier assets yield which, turn, How, measure bonds? intuitively appealing security's variability price. Higher means, probability returns, substantially negative statistical series standard deviation. broader spread, variable deviations three (i.e., portfolios stocks, bonds) consistent expectations Table 1). Over 1956–1976, provisionally accept deviation estimated too equity. recorded 1 confirm expectations. 0.74 percent, 0.54 0.32 percent. highest intermediate provided almost exactly mid-way stocks lowest portfolio). least preliminary basis, nothing suggest extraordinarily high. precise test 1956–1976. Where ranked portfolios' total returns), assessed normal systematic co-variability market).2 Briefly, (known “beta”) portfolio.3 Model, generated using alternate (systematic) To repeat earlier hypothesis, high–implying cost–the positive. If, hand, priced commensurate distributed zero, different zero. –0.07 percent sense, reliably calculations shown second column 2. 0.39 per month, 2 support assertion properly of, fair on, contention risk; investors, market. anything, (slightly) low period. turn law remove able deduct purposes. confirmed either conversations treasurer controller, examination annual reports accounts “In effort eliminate possibility spurious evidences indebtedness deduction, version 1954 act incorporated language might ended privilege. condition brought attention, legislators quick redraft measure. indicated ‘there slip twixt cup lip’ disallow true rule continues embodied Section 163(a) Internal Revenue Code 1954, allows within indebtedness.”4 Unfortunately, neither US Congress nor courts defined precisely equivalent. court IRS rulings, experts question characteristics. (This can, distant. An Elmyra & Williamsport Railroad, set 2862. 30- 50-year typical). Second, cannot discretionary. generally interpreted mean earned, cumulative due, event, date Conversations treasurers attorneys indicate instances, tests applied lieu interest: rank equally corporation's creditors liquidation; “arms-length” transaction. short, retain essential valid obligations, deductions continue IRS. Concern changes deter offered impose deadweight costs similar Bankruptcy proceedings typically involve fees lawyers, trustees, auctioneers, referees, accountants, appraisers. devotes restructuring operations largely costs. critics problem conflict Remember depend typically, under (or, generally, managers acting behalf). For performance, stockholders' depress avoid certain “truly” insufficient trickery. result, passed, incentive initiate against parties who proper compensation services. While could directly, did discover concerned specific ruled favor ordered previously involving Central Georgia Railway, occurred 1907–1910. methods second, recent, 1971–1973 Chicago, Milwaukee, St. Paul, Pacific Railroad Company outstanding Class-action suits filed behalf sets Chicago-Milwaukee primary points involved way subsidiary computed (or losses) included parent net point carry-forward losses Company, improper depressed earnings. On obliged $4.1 (less court-approved attorney's costs) agreed alter practices requested class-action suits.5 note omission does not, itself, generate resulting manipulations, easily When initially issued, weigh likelihood receiving accordingly. perceived highly volatile somewhat “unorthodox” practices), relatively investors. Management, therefore, investor where major problem. value loss dead-weight These us small, especially obligations. ways circumvent uncertainty. minimize completely eliminate) conceal done making cumulative, compounding comparable firm's current opportunity rate).6 inserting provisions, certain, offered, recover action. inexpensive reducing uncertainty). Hence, seen none reasons popularly stands up close scrutiny. switch focus positive: empirical financing? More precisely, rewards recent paper, attempted happens prices retire stock.7 comparison share just before, immediately after, announcement exchange viewed favorably, detect (arising price) announcement; adverse reaction Similarly, neutrality, indifference toward 22 completing bonds-for-preferred exchanges 1965. exchange, 87.8 offers represented, significant recapitalization companies.8 analyzed daily announcement. little impact value. exchanging positive, significant, absolute statistically. study telling. separately day announcement, days preceding date. presented 3. 1.45 0.73 plus one. announcement-day large, jargon, (The not.) say, great confidence, random chance. 1.01 1.47 after. Neither attributed chance either. here. hypothesis somehow “tainted.” shareholders clear, albeit preference theory evidence, contradicting popular objections extensive research indicates investors; expensive death.” legislation terminate existing rulings unlikely. easy “dead-weight” stockholder/income bondholder accumulate compound, reflecting capital, makes bondholder's initial offering. investigation benefited doing so; them shares. good Given instrument's unique characteristics, think increased structuring view placing unacceptable constraints flexibility, allow secure attendant meeting periodic facing consequences failure gain acceptance puzzle us. response pressures giving rise innovations, clients will, necessity, directed unexploited advisors ensure it.