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Recent developments in corporate finance.

Recent Developments in Corporate Finance

Recent years have seen dramatic changes in the financial structure of U.S. nonfinancial corporations, in corporate securities markets, and in corporate financing techniques. Many of these changes have been associated with the wave of mergers, acquisitions, and other corporate restructurings during the last half of the 1980s. In particular, the outstanding debt of the nonfinancial corporate sector soared as corporations borrowed heavily to finance retirements of equity resulting from restructuring activity. Furthermore, a substantial portion of this step-up in borrowing involved low-grade debt. At the same time, investors became more receptive to these bonds, responding to the promise of attractive yields and recognizing the opportunities for diversification of their portfolios. This shift not only provided funds for mergers and restructurings, but also enabled more firms that were less well-known to tap public debt markets.

With the repayment of the debt from many mergers hinging on subsequent sales of assets, acquirers turned to new sources of temporary financing from commercial and investment banks and made innovative use of bonds with deferred interest payments and variable coupon rates. Because bondholders were dissatisfied with losses occasioned by downgradings in the wake of unanticipated restructurings, many corporations included protection against this special risk in their new bond issues to reduce borrowing costs.

With the rise in debt, many measures of corporate financial condition deteriorated: Interest expenses claimed a significantly higher share of corporate cash flow; downgradings of debt accelerated; and bond default rates, while still relatively low, began to climb. In contrast, debt-equity ratios based on market values increased very little, as higher stock prices offset much of the growth in corporate indebtedness. Nonetheless, the nonfinancial corporate sector appears, on balance, to be more exposed to potential financial problems than it was in 1984. In this environment, banks and other investors have become more cautious in extending credit to finance highly leveraged mergers and acquisitions, a shift that has contributed to an increase in the use of equity financing and to a slowing in merger activity.

While the changes associated with the restructurings captured the public's attention, significant developments were occurring elsewhere during the last half of the decade. The differences between debt and equity as sources of funds to finance corporate activity narrowed significantly with the expansion in the use of financial instruments having features of both. Interest rate swaps and other methods for hedging interest rate risk also blurred the traditional distinction between short-term and long-term debt. Nonfinancial corporations relied more heavily on bonds, commercial paper, and loans from foreign banks for new funding and less on credit extended by domestic banks. For investment-grade nonfinancial corporations, medium-term notes became a growing source of funds. Issuance of privately placed debt was robust over the last half of the 1980s, despite growth in the public junk bond market, which many believed might supplant the private market. Moreover, in a recent ruling the Securities and Exchange Commission removed restrictions on secondary trading of private placements by larger institutional investors. The ruling likely will spur continued growth in the private market fed by increases in the participation by foreign issuers and, perhaps, by domestic issuers drawn from the public market.

Restructurings and Corporate Financial Developments

Merger and acquisition activity, which was instrumental in shaping corporate financial patterns, was strong throughout the decade (chart 1). The number of transactions rose moderately through 1983 and then accelerated between 1984 and 1986. Although the number fell over the remainder of the decade, it remained high by past standards. More important, the dollar value of the transactions continued to climb rapidly until 1989, easing only briefly in 1987, after the October stock market break. Acquisitions of U.S. firms by foreign companies since 1987 have added significantly to the volume of merger activity. Divestitures rose at a strong pace throughout the 1980s, accounting in the last five years for nearly one-third of the dollar value of all mergers and acquisitions.

Many explanations have been offered for the dramatic expansion of mergers and acquisitions. One is the search for the fullest potential of the firm's assets through a transfer of corporate control to new management teams. Another focuses on the tax benefits of higher leverage, the capture of tax-loss carryovers, and an increase in the asset basis used for depreciation allowances and other purposes (although the Tax Reform Act of 1986 and subsequent legislation essentially eliminated the last two incentives). A third explanation views the restructurings as vehicles for transferring wealth from bondholders, workers, and other corporate stakeholders to shareholders. A fourth ascribes the merger boom to highly sophisticated investors who doubted that the equity values of many firms fully reflected the appreciation in their assets during the inflation of the 1970s and early 1980s. These investors were aided by legal advisers and financial intermediaries who increased investors' awareness of the potential gains and developed financial instruments to facilitate the transactions. A final explanation points to a less restrictive antitrust enforcement policy that permitted most of the proposed mergers and acquisitions to go unchallenged. Although it is early to draw firm conclusions, preliminary research has suggested that several of these factors played a role in the restructuring boom.

Corporate Balance Sheets and Profitability

Whatever their cause, corporate restructurings have resulted in an unprecedented retirement of outstanding equity shares, which far outstripped the moderate level of new equity issuance (chart 2). Overall, retirements of nonfinancial corporate stock have exceeded new issues by about $600 billion since 1983, in sharp contrast to the rest of the postwar period, when retirements of shares exceeded new issues in only a handful of years, and then by very small amounts. Even the stock market break in 1987 had little effect on retirements because a pickup in stock repurchases by many corporations largely offset the brief pause in merger activity.

Unlike the mergers of the 1960s, which were financed largely by an exchange of securities, acquisitions in the 1980s relied heavily on borrowed funds to pay cash to selling shareholders. Leveraged buyouts (LBOs), the most highly leveraged acquisitions, mushroomed from less than $5 billion in 1983 to more than $60 billion in 1989, the year that included the $25 billion RJR-Nabisco transaction. LBOs served to transfer assets from publicly held corporations to

closely held partnerships and private corporations. Some were structured with as little as 10 percent equity, provided largely by buyout pools that takeover specialists assembled. To finance the remainder, the new firm effectively pledged the assets of the acquired company as collateral for new debt obligations. The LBO firms then sought to lower the debt burden through improved cash flow and sales of some operations. Many of these divestitures were themselves structured as LBOs.

In addition to financing LBOs and other mergers and acquisitions, debt commonly was used to finance defensive measures such as leveraged recapitalizations undertaken to discourage unsolicited or "hostile" takeovers. As a result of all these restructuring activities, the idebtedness of nonfinancial corporations grew rapidly, as illustrated by the sharp increase in the ratio of the market value of debt to the gross domestic product of nonfinancial corporations (chart 3).

The rapid buildup of debt in the nonfinancial corporate sector was accompanied by rising net interest payments that absorbed a growing share of corporate gross product (chart 4). The interest share expanded even though interest rates were lower, on balance, during the last half of the 1980s, and that expansion was one factor acting to depress corporate profitability. Before-tax profits slipped from roughly 9 percent of corporate output in 1987 to about 7 3/4 percent in 1989. Over the same period, net interest payments rose from about 4 1/4 percent to more than 5 percent of corporate gross product, accounting for more than half of the drop in the profits share.

Cyclical developments also played a part in the shrinkage of the share of before-tax profits. The slowing of gains in output and productivity toward the end of the decade, along with faster gains in compensation, squeezed corporate profits, especially in 1989. Moreover, in the face of foreign competition, businesses were forced to exercise restraint in passing rising production costs through to prices, further damping corporate profits originating from domestic operations.

The Tax Reform Act of 1986 had important effects on after-tax profitability. The average corporate tax rate on nonfinancial corporations--the ratio of federal, state, and local tax accruals to economic profits--rose from 31 percent in 1985 to 44 percent in 1989. Although the act reduced the maximum marginal rate of corporate taxation and permitted more accelerated depreciation for tax purposes, the elimination of the investment tax credit and of the preferential taxation of long-term capital gains more than offset these benefits. The increase in the corporate tax rate has meant that, over the past five years, before-tax profits have shown more strength, on balance, than after-tax profits. Combined with the loss of some nondebt tax shields, the increase in the effective corporate tax rate also may have strengthened the incentive to use debt finance, even for firms not directly involved in restructuring activity.

The use of debt to retire equity boosted corporate borrowing beyond that required to finance capital outlays. The financing gap, the difference between capital expenditures and internal funds, represents the extent to which corporations must draw on external sources of funds--credit market borrowing, new equity issuance, or asset liquidations--to finance capital expenditures. Although credit market borrowing exceeded corporations' needs for external funds for most of the postwar period, changes in total borrowing generally reflected changes in the financing gap. However, this pattern changed dramatically after 1983 (chart 5). The financing gap showed little trend between 1982 and 1989, while borrowing increased sharply, reflecting the surge in merger activity.

Merger Financing and the Junk Bond Market

Although the merger and buyout activity of the past decade contributed significantly to the radical transformation of the junk bond market, part of the early growth of that market was related to developments in private placements. Before the 1980s, few new speculative-grade bonds (bonds rated below Baa3 by Moody's Investors Service or below BBB- by Standard and Poor's Corporation) were publicly offered because most investors shied away from their higher risk of default. Higher-risk borrowers, typically small and medium-sized companies, tended instead to rely on loans from commercial banks and on private placements, primarily with life insurance companies. When policy loans began to absorb the investible assets of life insurance companies in the late 1970s and early 1980s, these institutions turned from the private placement market toward more liquid investments. Consequently, many of these higher-risk companies were forced to seek new sources of credit. In response, securities firms, led by Drexel Burnham Lambert, began actively promoting public offerings of high-yield bonds in the early 1980s. At the same time, institutional investors in the public market became convinced that the bonds' higher yields more than compensated for their greater risks, especially when the bonds were held in a diversified portfolio. The economic expansion also provided a favorable environment by seeming to mitigate risk.

These developments interacted with the growth of financing needs arising from mergers and restructurings to spur a dramatic increase in the issuance of junk bonds. Between 1983 and 1989, nonfinancial corporations issued $160 billion of junk bonds to the public; that sum accounted for more than 35 percent of public bond offerings by the sector. About two-thirds of the high-yield bonds offered during this period were associated with restructurings--leveraged buyouts, other mergers and acquisitions, divestitures, stock repurchases, leveraged recapitalizations, or other restructuring activities (chart 6). In most cases, junk bonds provided permanent [Graphs 1 to 6 Omitted]

This article was prepared by Leland E. Crabbe, Margaret H. Pickering, and Stephen D. Prowse of the Board's Division of Research and Statistics. Brian H.Levey provided research assistance. financing for cash buyouts, which replaced part or all of the funds supplied initially by commercial or investment banks.

As the high-yield market matured, new instruments that offered issuers greater leeway in managing the timing of their interest payments were introduced. These instruments grew out of the need to minimize interest payments until cash flow improved or until debt loads could be reduced with the proceeds from sales of assets. The deferred-cash-payment bond and the reset note were commonly used for these purposes.

Deferred-Cash-Payment Bonds. Several types of bonds enable borrowers to postpone the cash payment of interest. Payment-in-kind (PIK) bonds give the issuer the option of issuing more debt in lieu of a cash coupon payment over the first years of the bond's life. These bonds typically have a stated maturity of about ten years, and a payment-in-kind period of about five years. After this period, the issuer must make the coupon payment in cash. Original-issue-discount (OID) bonds also delay cash interest payments. These bonds, which are issued at a large discount from par, include zero coupon bonds and bonds with coupon rates set well below market yields at the time of issuance. After an initial period, the coupon rate is raised. Because securities with deferred cash payment typically have a subordinated standing in the issuer's capital structure and shorter call protection than conventional debt, their yields to maturity tend to be at least 200 basis points above those on conventional debt. Moreover, the returns on deferred-cash-payment bonds usually are more volatile than those on straight debt, reflecting their junior standing and longer duration.

During the years 1987-89, PIK and OID bonds accounted for more than 15 percent of new funds raised in the junk bond market (table 1). Until recently, issuers of PIK bonds were allowed to deduct coupon payments on the additional debt as an interest expense, even though no cash outlay was made. Similarly, issuers of OID bonds were allowed to deduct the accrued interest as an expense. As a result of legislation passed in 1989, however, no interest deductions are allowed on that portion of the accrued interest that is 6 percentage points above the yield on comparable Treasury securities; and the interest expense corresponding to the yield that is between 5 and 6 percentage points above comparable Treasury securities can be deducted only at maturity. The legislation has greatly reduced the attractiveness of issuing debt with delayed cash payments.

Reset Notes. Reset notes have characteristics of both floating- and fixed-rate debt. The coupon rate is fixed for an initial period, usually one to three years, after which it is reset to make the bond trade at a predetermined, or reset, price, usually 100 to 102 percent of par value. The coupon rate would be raised if the market price were less than the reset price and lowered if the market price were greater than the reset price.

The reset feature appeals particularly to firms that anticipate improvements in their credit quality before the reset date, for they will be able to benefit from lower borrowing costs. The appeal may be especially great to companies that have experienced a downgrading in credit rating as a result of a buyout but expect debt paydowns from asset sales to lead to an upgrade.

From the investor's viewpoint, the reset feature offers some protection against a deterioration in an issuer's credit quality. This protection is, however, limited to modest declines in credit quality because if the issuer faces severe financial distress, there may be no affordable coupon rate that makes the note trade at its reset price. Moreover, even if its financial condition is not deteriorating, the company may have to raise the coupon rate if the reset date falls in a period of heightened concerns about credit quality. To lessen the risk that reset notes will exacerbate financial stress, many issuers place caps on the coupon rate. More than two-thirds of the notes yet to be reset have caps, generally ranging from 100 to 400 basis points above the original coupon rate. Since this type of security first appeared in the U.S. public market in 1985, more than fifty reset notes, with an aggregate face value of about $13 1/2 billion, have been issued in the junk bond market. The dollar volume accounts for about 7 1/2 percent of public issuance of junk bonds during this period. By year-end 1989, about a dozen of these publicly issued reset notes had been either called or reset. In addition to issuance in the public market, at least $2 3/4 billion was placed privately between 1987 and 1989.

Corporate Credit Quality

The increase in the use of debt finance has been associated with a deterioration in many indicators of corporate financial health. Interest payments in the aggregate have claimed an increasing proportion of the cash flow of nonfinancial corporations since 1983 (chart 7). Furthermore, the number of firms whose interest expense exceeded cash flow rose significantly between 1983 and 1988, despite favorable economic conditions and falling interest rates. In these circumstances, concerns have arisen about the ability of highly leveraged firms to service their debt, especially in light of the slowing of the economy in 1989.

The secular erosion in corporate credit quality accelerated in the last half of the 1980s, an erosion evidenced by the increase in downgradings of corporate bonds relative to upgradings. The growth in new issues by lower-rated firms, which are more prone to downgradings, has meant that more frequent changes in credit ratings are likely. Nonetheless, the general deterioration in creditworthiness is noteworthy because it occurred while the economy was expanding.

As a result of these changes in ratings, the median rating that Standard and Poor's assigned to industrial bonds dropped from an investment-grade A in the early 1980s to a below-investment-grade BB at the close of the decade (chart 8). One-third of the estimated $600 billion of rated nonfinancial corporate bonds outstanding at the end of 1989 was rated as noninvestment grade. In the early 1980s, before the recent wave of restructurings, these low-grade bonds accounted for less than one-tenth of the total outstanding.

Some of the growth in below-investment-grade debt stemmed from the downgrading of outstanding debt to speculative grade because of events related to restructuring. More important, that growth was boosted by new debt issues of these downgraded companies. Furthermore, in the late 1980s, many new issues carried ratings at the lower end of the credit spectrum--B and Caa on Moody's scale. In the past these ratings generally appeared only when corporations on the edge of default were downgraded. The relative importance of the other component of speculative issuers, those companies downgraded to noninvestment grade because of a long-term decline in business fundamentals, has changed little over the past ten years.

Default rates on corporate bonds of below-investment grade, while still low, have risen, from 1.4 percent of outstanding bonds in 1987 to 4 percent in 1989 (table 2). Moreover, many market analysts expect much higher default rates over the next few years, both because the overall quality of the noninvestment-grade bonds has declined and because defaults tend to rise as bonds age. Indeed, several recent studies have found cumulative default rates for particular cohorts of bonds to be as high as 30 percent over the first ten years after issue.

Other measures of the condition of corporate balance sheets suggest that stockholders have not been overly concerned with the growing indebtedness of corporations. In particular, the ratio of debt to equity, both measured at market values, has increased only slightly since 1982, as rising equity prices have largely countered the rise in corporate indebtedness (chart 9). Nevertheless, the deterioration in other indicators of corporate financial condition, especially the ratio of interest expense to cash flow, indicates that the financial health of the business sector may be vulnerable to a significant slowing in economic activity.

Event Risk

About one-fourth of the reductions of ratings in the past five years were related to restructurings. The downgradings were concentrated in the industrial sector, where leverage-increasing events occasioned downgradings for about 40 percent of outstanding bonds. According to Moody's Investors Service, these downgradings inflicted losses of nearly $14 billion on bondholders between 1984 and 1988.

As a result, investors in industrial bonds became increasingly sensitive to event risk--the risk that an unforeseen, major change in a firm's capital structure will lead to a large decline in the market value of the firm's outstanding bonds. To compensate investors for event risk, yields on investment-grade industrial bonds rose relative to yields on high-grade utility bonds. After the RJR-Nabisco buyout proposal in late 1988 dispelled the notion that bonds of very large industrial corporations were free of event risk, investors stepped up their demands for stronger bond covenants for protection against that risk, and several issuers have found it worthwhile to comply. The terms of the covenants have varied from issue to issue, but they have had common features. For example, most covenants written since late 1988 have specified that bondholders may sell their bonds back to the issuer at par if two events occur: a major change in the issuing firm's capital structure and a downgrading of the bond by the major rating agencies from investment grade to speculative grade. In 1989, nearly half of the new offerings of long-term bonds by investment-grade industrial firms included event-risk covenants. Estimates suggest that industrial firms have saved about 1/4 percentage point on borrowing costs by including this protection.

RECENT DEVELOPMENTS IN MERGER AND RESTRUCTURING ACTIVITY

Early in 1989, the hectic pace of debt-financed restructuring began to subside. The amount of stock-for-stock exchanges in merger transactions rebounded in 1989 from the extremely low levels of 1987 and 1988. This rebound largely reflected the increase in emphasis last year on friendly strategic corporate acquisitions in which the new, combined company issued new common shares to stockholders of the two original companies. Then, late in the year, the deepening difficulties in the market for below-investment-grade bonds further encouraged combination offers of cash and securities, particularly preferred stock, to shareholders of the acquired company.

The acquisition market was jolted last fall when a few companies involved in highly leveraged transactions failed to perform up to expectations, defaulted on bond issues, and sought bankruptcy protection. Others, seeking to prevent default, have reached agreement with bondholders to reschedule debt or are attempting to do so. These "distressed" exchanges typically replace existing debt with securities carrying a longer maturity, lower interest rate, some substitution of equity, or a combination of these features; and they must be approved by a predetermined share of bondholders specified in the original bond's covenant. Whereas such exchanges are still few, these unravelings of acquisitions and the general vulnerability of highly leveraged firms to adverse economic developments have heightened concerns in the financial markets; and thus they have made investors much more cautious in extending funds to highly leveraged borrowers.

Uneasiness about rising bond defaults contributed to chaotic conditions in the market for speculative-grade bonds early this year as prices of restructuring-related issues dropped precipitously. The withdrawal of the savings and loan associations from the junk bond market and outflows from high-yield mutual funds further curtailed demand for these issues. The liquidation of Drexel Burnham Lambert early this year was another negative factor for the market to absorb, even though Drexel's participation had already dwindled.

New merger proposals dropped off noticeably during the first part of 1990 as a consequence of the virtual unavailability of funds for new financing in the low-grade bond market; the more cautious attitude of commercial banks, both domestic and foreign; and the weakening in the market for asset sales. Nevertheless, although restructuring activity is considerably less than it was in 1988 and 1989, it remains substantial. Despite the disarray in the junk bond market and investor caution, well-structured acquisition proposals, especially those aimed at enhancing a firm's competitiveness within its own lines of business, have been well received by investors.

IMPLICATIONS OF FINANCIAL INNOVATIONS

The past several years have seen many shifts in the relative importance of various debt instruments in financing business activity (table 3). One of the most significant changes has been the increase in the importance of bonds and notes, which were responsible for roughly 58 percent of estimated total credit market debt raised in 1989, compared with 46 percent in 1983. Another has been the steady decline in loans from domestic banks over the same period, from 32 percent of total credit market debt to 14 percent. Loans from foreign banks, on the other hand, increased, to just under 7 percent of total credit market debt raised in 1989; and the issuance of commercial paper continued its rapid expansion, interrupted only by a pause in 1986. The strong growth has been fueled by heavy inflows to money market mutual funds, which are the largest buyers of commercial paper.

The implications of these changes for the maturity structure of the corporate sector's debt are not so clear as they would have been in the past. For one thing, many of the financial developments and innovations in the past decade have eroded the traditional distinctions between short- and long-term debt, as well as those between debt and equity. Furthermore, a recent regulatory change by the Securities and Exchange Commission (which is discussed in some detail below), has blurred the traditional distinction between private and public markets for securities.

Short-Term and Long-Term Debt

Before the 1980s, it was reasonable in aggregate analysis to characterize commercial paper and bank loans as short-term debt and corporate bonds and mortgages as long-term debt. Such characterizations often were used to gauge corporate exposure to interest rate and liquidity risk, under the assumption that interest rates on short-term debt were variable whereas those on long-term debt were fixed.

Financial developments and innovations in the past decade have made this classification of debt less useful. One such development is the $1.3 trillion swap market. In an interest rate swap, an issuer of fixed-rate debt, for example, agrees with a counterparty--typically a swaps dealer--to make floating-rate payments in exchange for fixed-rate payments. Because the fixed-rate issue often has an intermediate or long-term maturity, the exchange effectively allows the fixed-rate issuer to convert its debt into an obligation with an essential feature of short-term debt. By the same token, a floating-rate issuer can convert its interest obligations to a fixed rate through a swap, thereby lengthening the duration of its debt. In a similar sense, currency swaps have blurred the distinction between debt denominated in dollars and in foreign currencies. In a currency swap, an issuer of, say, dollar-denominated bonds agrees with a dealer to make principal and interest payments in, say, French francs, and in return the dealer provides the issuer with dollar payments for the principal and interest on the issuer's bonds. The swap protects against foreign exchange risk.

Related transactions, such as caps, floors, and collars, can be used to alter the characteristics of floating- and fixed-rate debt. A cap places a maximum on the interest rate paid by a floating-rate issuer: The seller of the cap agrees to provide funds to the holder of the cap to cover the interest payments that exceed a specified rate. Similarly, a floor places a minimum on the interest rate a floating-rate issuer is required to pay. And a collar combines a cap and a floor to confine the interest rate to a given range. The tighter the range associated with the collar, the closer the floating-rate obligation comes to fixed-rate debt. By similar reasoning, an issuer of a fixed-rate security can use caps, floors, and collars to introduce elements of short-term debt into its obligation.

The introduction of extendible notes, which give the issuer the option of extending the maturity of an issue, also has eroded the differences between intermediate- and long-term securities. Some extendible issues permit the issuer to extend the maturity for one, two, or three years and permit the exercise of this option for up to seven years. On other notes, the feature is more rigid, specifying a date on which the option may be exercised to extend the maturity to a specified number of years. Frequently, the option to extend has been included in offerings of reset notes, with the coupon reset if the issuer exercises the option.

Medium-Term Notes

In the corporate bond market, the classification of bond issuance as long-term financing also has become less meaningful as the market for medium-term notes has grown. Medium-term notes are continuously offered corporate bonds that generally are sold by agents on a "best efforts" basis; they have maturities that usually range from one to five years (utility issues, however, routinely have thirty-year maturities). The market for medium-term notes, which expanded rapidly after the Securities and Exchange Commission began permitting so-called shelf registration of security offerings in 1982, was dominated at first by the finance subsidiaries of automobile companies, but by 1989 more than 200 U.S. corporations had raised funds in the market; the gross issuance in that year was $35 billion (table 4). Offerings of medium-term notes by nonfinancial firms are likely to rise further as more of these issuers establish new programs and as others draw down on established programs. Continued growth of issuance by nonfinancial corporations also appears likely to produce a lengthening in maturities.

At first, many borrowers used medium-term notes to raise relatively small amounts of funds quickly, since the market afforded a flexible means to match the maturities of intermediate-term assets. Primary issues averaged about $5 million. As the market has matured, medium-term notes have become more competitive with traditional corporate underwritings, and trades have approached $50 million to $100 million. Most issuers have investment-grade ratings: Of the $72 billion in medium-term notes outstanding at the end of 1989, only $1 1/4 billion had ratings below investment grade, and most of those notes were issued originally as investment-grade debt. Some recent programs by nonfinancial issuers have included covenants that protect against event risk.

Although the market for medium-term notes was structured as an extension of the commercial paper market, its recent growth may be attributable to a shift from traditional markets for intermediate-term financing, particularly the Eurobond market. (Eurobonds are bonds issued outside of the home market.) Favorable interest rates and the removal of the withholding tax on interest paid on bonds to foreign investors fostered borrowing by U.S. corporations in the Eurobond market in the mid-1980s (table 5). Since 1986, as the rate advantage in the Euromarket has diminished, U.S. corporate borrowing in that market has fallen off. Although several U.S. corporations have established global programs for issuing medium-term notes, issuance abroad has not grown so fast as domestic issuance. On the demand side, a high degree of sensitivity of foreign investors to the threat of event risk damped demand in the Euromarket for U.S. corporate issues, particularly issues of non-financial corporations.

Debt and Equity

The difference between debt and equity as sources of corporate financing has narrowed significantly. One factor has been the expansion of the market for speculative-grade bonds. Because low-grade bonds typically have a junior standing in the issuing firm's capital structure and, more important, because their high returns are particularly vulnerable to a drop in earnings, these bonds have risk and return characteristics similar to those of both common stock and debt. In addition, many new offerings of speculative-grade bonds have been convertible into equity or have included equity-like features, such as warrants. There also has been an expansion in the issuance of a kind of preferred stock that gives the issuer the option to exchange it for debt. Most of this exchangeable preferred stock has been placed directly with shareholders as part of leveraged restructurings. Many of the issuing firms have exercised the exchange option.

Innovations in the use of variable-rate preferred stock likewise have served to narrow the difference between debt and equity. Because corporations are allowed to deduct 70 percent of the dividend income they receive from unaffiliated corporations, fully taxed corporate investors, given all else, favor preferred stock over debt investments. Variable-rate preferred stock combines this tax advantage with a floating dividend rate that makes the stock a substitute for commercial paper. The dividend rate is commonly adjusted several times a year either by a remarketing agent or through a Dutch auction, in which bids are ranked from lowest to highest and the highest bid that clears the issue will be the price paid for the bids by all winning bidders regardless of their initial bid. The rate is often capped at 110 percent of the AA-rated commercial paper rate. The caps lend variable-rate preferred stock an equity feature, inasmuch as buyers of these securities bear the risk of a price decline should the cap become effective.

Private Placements

The private market, in which corporate securities are placed directly with institutional investors, has grown steadily since the early 1980s, and in 1988 and 1989, the volume of privately placed bonds exceeded that of publicly offered bonds (chart 10). While the extraordinary expansion in the public market for non-investment-grade debt is partly an outgrowth of the private placement market, the public market has not supplanted the private one. Life insurance companies and pension funds have found in the private market an attractive outlet for their growing pool of investible funds. The wave of corporate restructurings spurred this growth, as many firms involved in restructuring tapped the private market for part of their financing.

The lines between public and private markets have faded because major lending institutions and corporations participate in both markets. The difference between private and public offerings is expected to narrow even further now that the Securities and Exchange Commission has adopted Rule 144A. The rule exempts U.S. and foreign corporations from registration requirements for bonds and stock sold to institutional investors with investment assets of $100 million or more (and, in the case of banks and thrift institutions, net worth of at least $25 million). Perhaps more important, the rule permits the resale of these private securities to qualified institutions at any time. Before the new rule was promulgated, private securities generally could not be resold for two years, although some carried registration rights that permitted their subsequent unrestricted resale in the public market. The National Association of Securities Dealers' screen-based trading system, called Portal, is designed to increase liquidity in the marketplace for primary and secondary market sales of 144A securities. The additional liquidity in the private market is likely to attract new buyers and issuers, both domestic and foreign. It also may draw in mutual funds, pension funds, and other lenders who have faced restrictions or limitations on their holdings of nonregistered securities. [Graph 1 to 10 Omitted] [Tabular Data 1 to 5 Omitted]
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Author:Prowse, Stephen D.
Publication:Federal Reserve Bulletin
Date:Aug 1, 1990
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