Abstract: This paper applies a contingent claims approach to examine the duration of a zero coupon bond subject to default risk. One replicating portfolio for a default-prone zero coupon bond contains a long position in the default-free asset plus a short position in a put option on the underlying assets. The duration of the bond is shown to be a weighted combination of the duration of the default-free bond and the put option. The duration is less than maturity and is not an immunizing duration. The technique is then extended to subordinated debt. DURATION IS A SUBJECT of much concern to researchers and bond portfolio managers. In the last five decades, the literature on duration has grown from a simple explication of its property as a measure of average maturity (Macaulay (1938)) to sophisticated strategies such as funding multiple liabilities (Fong and Vasicek (1984)). Duration, however, is not without its critics. For example, the simplest framework for a duration model, a world of parallel yield curve shifts, is not only an unlikely state of nature but is also inconsistent with equilibrium (Ingersoll, Skeleton, and Weil (1978)). Fortunately, however, Bierwag, Kaufman, and Toevs (1982) have shown that a given duration measure, even the simplest one, can be consistent with equilibrium, as well as disequilibrium, processes. Thus, it should not be too surprising that, in spite of its limitations, duration is still widely used today in bond portfolio management. Although progress and, in some cases, solutions have been developed for a number of practical and theoretical problems in duration, many remain unsolved. For example, the effect of default risk on duration is currently unknown. It hardly seems wise to assume that default-free duration strategies will be appropriate for default-prone markets. In a world of contingent claims contracting, however, investors can separate default effects from interest rate effects. Given the large size of the market for default-prone bonds, it is obvious, nonetheless, that many investors choose to accept both risks.1 Therefore, the extent to which default premia are affected by interest rates, and, thus, have a potential impact

Abstract: This paper examines the pricing of exchange-traded long-term corporate bond portfolios. Observable instruments measuring the term structure of interest rates, levels of bond and stock prices, and a January dummy are found to predict excess returns on corporate bonds. An intertemporal asset pricing model with changing expectations and unobservable factors is then estimated for the predictable excess returns using Hansen's Generalized Method of Moments. The results show that a multibeta linear time-varying model of con? ditional expected returns with constant betas can successfully value corporate bonds. Spe? cifically, the tests indicate the presence of two time-varying hedge portfolios. The data, however, support a single latent variable specification when all January observations are excluded. This result suggests the existence of a strong January seasonal in one of the latent variables.

Abstract: This article proposes a two-step method for estimating the impact of bond indenture provisions and other financial variables on the risk and yields of investment-grade and speculative corporate bonds. In the first step, the default risk of bonds is estimated as a function of indenture provisions and the characteristics of bonds and the issuing firms by an ordered probit. In the second step, the effects of default risk and bond characteristics on yields are estimated after a measure of bond default risk is obtained by a conditional-mean method.

Abstract: In a frictionless market with perfect information, a shareholder-wealth- maximizing firm should force conversion of its convertible bond issue into stock as soon as the bond comes in-the-money. Firms however appear to systematically delay forced conversion, sometimes for years, beyond this time. We show that the observed delays can be plausibly explained in terms of costs to shareholders of a failed conversion and the ensuing financial distress. Firms delay the forced conversion to avoid the self-fulfilling outcome that bondholders expect the conversion to fail, tender their bonds for cash, and the stock price falls to account for the costs of financial distress, in which case tendering for cash is in fact optimal. Unlike other explanations of delayed forced conversion, we can explain the common use of investment banks to underwrite these transactions, since the banks can eliminate the self-fulfilling bad outcome.

Abstract: This is a study of the high yield bond market, popularly called `junk bonds.' Glenn Yago has studied how companies that use junk bond financing compare in economic performance with their industry averages. This book shows that, contrary to what might be assumed, especially in view of the mixed reputation junk bonds have, the performance of these companies was superior in the vast majority of cases.

Abstract: In a frictionless market with perfect information, a shareholder-wealth- maximizing firm should force conversion of its convertible bond issue into stock as soon as the bond comes in-the-money. Firms however appear to systematically delay forced conversion, sometimes for years, beyond this time. We show that the observed delays can be plausibly explained in terms of costs to shareholders of a failed conversion and the ensuing financial distress. Firms delay the forced conversion to avoid the self-fulfilling outcome that bondholders expect the conversion to fail, tender their bonds for cash, and the stock price falls to account for the costs of financial distress, in which case tendering for cash is in fact optimal. Unlike other explanations of delayed forced conversion, we can explain the common use of investment banks to underwrite these transactions, since the banks can eliminate the self-fulfilling bad outcome.

Abstract: The recent introduction of CPI-linked bonds by several financial institutions is a milestone in the history of the U.S. financial system. It has potentially far-reaching effects on individual and institutional asset allocation decisions because these securities represent the only true long-run hedge against inflation risk. CPI-linked bonds make possible the creation of additional financial innovations that would use them as the asset base. One such innovation that seems likely is inflation-protected retirement annuities. The introduction of index-linked bonds eliminates one of the main obstacles to the indexation of benefits in private pension plans. A firm could hedge the risk associated with a long-term indexed liability by investing in index-linked bonds with the same duration as the indexed liabilities.

Abstract: Previous research has suggested that, prior to the 1986 Tax Reform Act, the optimal strategy for tax-paying investors was to hold bonds in their pension fund and stock outside the fund. Given pension funding rules, however, it is likely that a better strategy would have been to employ some combination of risky assets and bonds. This is because risky assets expand the tax-exempt base beyond the full-funding limits defined in the Internal Revenue Code. A steady-state pension plan with either a balanced portfolio of bonds and stock or an all-stock portfolio would have generated tax benefits only about two-thirds as high as the tax benefits to an all-bond alternative prior to 1986. But a dynamic strategy that called for an all-stock portfolio until substantial funding was achieved, followed by a switch to an all-bond portfolio, would have far outstripped the tax gains from a static all-bond portfolio. The incentive to hold bonds in pension portfolios was substantially reduced by the Tax Reform Act of 1986. Elimination of the special capital gains tax substantially reduced the previous inequality between pre-personal-tax bond and equity returns. The new legislation left unaffected, however, the trust-expanding benefits of risky assets. Asset allocation strategies calling for substantial stockholdings thus become optimal under current tax laws.

Abstract: A personal computer system or workstation is arranged to display pertinent trading data in separate windows of a display. A trading window is sub-divided into separate windows, for the display of rich securities data, customer data, bond yield data, and cheap securities data. Upon initiation of a trade, buy/sell tickets and transaction confirmation notices are also displayed. Once a rich bond is selected, a list of customers owning the bond is displayed in another window. Also, the bond yield data is calculated over a period of time and plotted in another window. Yield data for the cheap bond is also plotted in the same window as the rich bond yield data. Once a customer decides to make the trade, buy and sell tickets are completed and the trade order sent to the backroom for completion.

Abstract: The insensitivity of sovereign loan secondary market returns to macroeconomic fundamentals has been attributed to market illiquidity and the absence of publicly reported transactional prices. During the 1920s and 1930s sovereign bonds were traded in an active market and weekly transactional prices were publicly available. This paper shows that price changes from both eras are insensitive to unexpected changes in key external and country-specific macroeconomic aggregates, but that returns are moved by individual agent announcements that presage changes in future lending. The results, which contrast with studies of U.S. equities, indicate that the sovereignty of the issuer matters more than the type of debt contract.

Abstract: This paper presents a model of debt finance at the sub-national level from which municipal bond supply equations are derived. Federal tax considerations are shown to be important determinants of the price entering the bond supply equation. Using data on 40 state governments over a seven year period in the 1980s, I show that federal tax rates have an important effect on the supply of municipal bonds - independent of the demand side effect that is usually considered in the literature. Furthermore, the effect persists after controlling for capital expenditures, thereby suggesting that municipal bond proceeds are fungible at the margin. This has implications for the measurement of the tax expenditure associated with tax exempt debt.

Abstract: This paper develops three empirical estimates of the value of the quality delivery option implicit in the Treasury bond futures contract: (a) an ex ante value as given by the excess of forward price of the cheapest-to-deliver bond over its conversion factor times the futures price; (b) an ex post value equal to the payoffs to a strategy of buying and holding a short-futures long-forward position at the start and delivering the cheapest bond at the expiration of futures contract, and (c) another ex post value equal to the sum of payoffs to a continuous rollover strategy involving a short-futures long-forward position in the cheapest-to-deliver bonds. Three months prior to delivery the average values of the three estimates are $464, $329, and $2,075, respectively. The differences among the three estimates appear to be largely due to nonsynchronous spot-futures data.

Abstract: An infinite-horizon investment-consumption model is considered in which the wealth of a single agent is consumed and distributed in two assets, a bond and a stock. The problem of maximization of the total utility from consumption is treated. State (amount allocated in assets) and control (consumption, rates of trading) constraints are present. It is shown that the value function is the unique viscosity solution of a system of variational inequalities with gradient constraints. >

Abstract: This paper considers the behavior of the yield differential between government and nongovernment bonds in Italy between 1976 and 1988. It is shown that the trend increase of the differential observed in this period was significantly influenced by the deterioration of public finances, as reflected both by an increase in the relative supply of government with respect to nongovernment paper and by a worsening of selected default risk indicators. In addition, the effect of relative supply factors was found to be statistically more robust and quantitatively more important than the effect of risk indicators in explaining the movements of the yield differential.

Abstract: A lthough most applications of duration we for bond portfolios, duration measures generally we derived for individual securities, not for portfo'ios. Portfolio durations usually are computed by av?raging the durations of the composite individual jecurities obtained by one of two ways: 1) from fornulas based on projected future cash flows and an assumed stochastic process, or 2) empirically as a ,rice elasticity from past data. The literature with one ?xception has considered only portfolios in which all ,ends of equal maturity trade at the same interest .ate, that is, all bonds trade on the same term strucure. This article expands the analysis to portfolios if bonds that trade at different interest rates even hough they have the same maturity, that is, trade )n different term structures, because of, say, differmces in credit quality. For such portfolios, two conlusions emerge: 1) portfolio duration is dependent an the future value of portfolio cash flows at the duation date, and 2) the weights used to obtain the tortfolio duration from the individual durations of .le composite securities are also dependent on the Jture values of the securities at the duration date. l e s e results suggest that portfolio durations ob2ined by applying present value weights to average idividual bond durations, the usual practice, are inorrect and introduce additional stochastic process :sk. For the sake of simplicity, the analysis in this aper is restricted to Macaulay durations and sto.iastic processes that are consistent with Macaulay durations. At the same time, the results can be generalized to include stochastic processes that are consistent with other measures of duration.'

Abstract: High-yield bonds that eventually run into serious credit problems do not, as a rule, come to market looking like average-quality issues Initial offering spreads tag them as potentially troubled situations from the outset, according to data collected on 1985 underwritings Probably more surprising to those who consider the market reasonably efficient is the finding that the 1985 newissue spreads on the very riskiest issues, although exceptionally wide, were not wide enough to compensate for credit-related losses In light of the data presented, reaching for maximum yield appears to be a questionable strategy for buyers of non-investment-grade bonds Superior analytical skills, focus on secondary-market opportunities or the availability of historically large risk premiums or equity kickers might modify that conclusion, however

Abstract: Muhammad Anwar's "Modelling Interest-Free Economy: A Study In Macroeconomics and Development" (1987) and subsequent comment by Tekir (1989) deserve serious consideration. Anwar's general macroeconomic model is one of the few models which offer a synthesis of traditional Classical and Keynesian models of macroeconomy. However, there are some fundamental theoretical and empirical weaknesses, some of which will be discussed briefly. Although the proposed "Interest-Free" monetary system is based on the principle of competitive markets (Tekir, 1989), it has no explanation for the extent of government's involvement in the macroeconomic activity. Even if we temporarily set aside the implicit assumption of a morally just monetary system, the proposed system of "Mudarabas" has serious limitations. For instance, the government purchases of goods and services will have to be either financed by increased taxes, monetization or by selling "Mudarabas" in the National or international market. (1) The "Mudaraba" contracts will replace the traditional bond-financed method of borrowing by government. If we rule out the highly inflationary monetization method, the only plausible method is the sale of "Mudarabas." It will tend to have the same degree of crowding out as expected in the bonds-financed method. As pointed out by Tekir (1989), the system opens itself to an undue intervention by government and lacks efficient allocation of resources. It is likely that a politically determined allocation of resources by government will be less than efficient. Moreover, the traditional productivity-based method of evlauating the benefits cannot be used. The output produced in the public sector may be evaluated on non-market criteria, an aspect completely ignored by Anwar's model. On a more general level the concept of "Mudarabas" will eliminate the bonds market and replace that with an equity market. This will be an equivalent of the stock market, which shows the strong, speculative element worldwide, an activity discouraged by Islamic economics. The stock market volatility in the U.S. and worldwide in 1987 and 1989, shows that the "Mudaraba" market will have to be modified to reduce the element of speculation. In more recent years, real estate markets in many Muslim countries have shown tremendous overvaluation due to highly speculative activities. An inflationary pressure in Mudaraba-based economy may also be another cause of volatility. Lastly, Anwar's claim that interest rates are negatively associated with budget deficits lacks empirical evidence. There is some evidence (Volker ...

Abstract: The behavior of the yield differential between government and nongovernment bonds in Italy between 1976 and 1988 is considered. The trend increase of the differential in this period was significantly influenced by the deterioration of public finances, as reflected both by an increase in the supply of government paper relative to nongovernment paper and by a worsening of selected default-risk indicators. The effect of relative supply factors, in turn, was found to be statistically more robust and quantitatively more important than that of risk indicators in explaining movements in yield differentials.

Abstract: The objective of this study is to determine whether investors perceive utilities with nuclear plants to be more risky than utilities with no nuclear facilities . Two basic analytical frameworks are used. One approach is to analyze investors' differential perception of the market-related systematic risk of nuclear utility stocks versus non-nuclear utility stocks. This is done by comparing the betas of nuclear versus non-nuclear utility stocks. The second approach is an econometric treatment of price to book value ratios , using cross-sectional data in the time period 1973 to 1987. For both approaches, the differences in the financial markets' perception of risk, related to the special events of TMI, Chernobyl and the WPPSS bond default, are analyzed. Based on the crosssectional analysis of P/BV ratios in recent years, we estimate the financial markets valued nuclear power utilities at approximately 20% less than comparable non-nuclear utilities. We estimate that a 3% increase in the allowed rate of return for nuclear utilities (from 13.7% to 16.7% in 1988) would have been necessary to fully offset the discount associated with nuclear power.

Abstract: Announcements of successful leveraged buyouts (LBOs) during January 1985 to April 1989 caused a significantly negative return on outstanding publicly traded nonconvertible bonds. Yet the average risk-adjusted debt holder losses are less than 7 percent of the average risk-adjusted equity holder gains. Bond losses are related to the pre-LBO rating, but only weakly to equity holder gains. We demonstrate that trader-quoted data from a major investment bank offers conclusions about the effects of LBOs on debt holders different from those drawn from commonly used matrix and exchange-based data (such as Standard & Poor's Bond Guide data). This has important implications for event studies involving debt instruments. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.(This abstract was borrowed from another version of this item.)

Abstract: The problem of maximizing expected utility of final wealth in an incomplete market is investigated The incomplete market is modelled by a bond and a finite number of stocks, the latter being driven by a d-dimensional Brownian motion The coefficients of the bond and stock price processes are adapted to this Brownian motion, and the number of stocks is less than or equal to the dimension of the driving Brownian motion It is shown that there is a way to “fictitiously” complete this market so that the optimal protfolio for the resulting completed market coincides with the optimal portfolio for the original incomplete market A number of equivalent characterizations of the fictitious completion are given, and examples are provided

Abstract: This paper tests whether the August 1982 advent of the Latin American debt crisis affected the implicit value of commercial bank loans to major Latin American debtors and hence, the value of equities. In contrast to previous studies, the analysis provides an explicit derivation of the theoretical impact of such an effect, uses a more efficient pooled cross-sectional, time-series estimating technique, addresses the question of whether (ex ante) required returns on bank equities also were affected, and compares the estimates to the behavior of the direct market for Latin American bonds. The results imply that the crisis did cause significant debt discounting as well as an increase in required returns. However, unlike the bond market, most of this equity effect was delayed 6–9 months.

Abstract: Japanese banks are promising sources of capital for developing countries wishing to finance a balance of payments gap. This paper shows that Japanese banks are highly capitalized in terms of market value; much of their capital is"hidden capital,"the divergence between accounting and stock market estimates. The authors developed a method for testing hypotheses about two types of hidden capital: the misvaluation of on-balance-sheet items and intangible values that the General Accepted Accounting Principles (GAPP) currently designates to be unbookable off-balance-sheet items. They construct a model that explains changes in both types of capital functions of holding-period returns earned in Japan on stocks, bonds, yen, and real estate. They apply the model to annual data for 1975-89 and a four-class size/charter participation of the Japanese banking system. For each type of hidden capital and each class of bank, the model develops estimates of the stock market, interest rate, foreign exchange, and real estate sensitivities of returns to bank stockholders. Only the stock market sensitivities prove significant, at 5 percent. Time-series regressions show that the large Japanese banks have developed stock market betas over two and that the value of the bank's beta has come to increase with measures of its size and accounting leverage.