Abstract: In recent years, the number of downgrades in corporate bond ratings has exceeded the number of upgrades, leading some to conclude that the credit quality of U.S. corporate debt has declined. However, an alternative explanation of this apparent decline in credit quality is that the rating agencies are now using more stringent standards in assigning ratings. An ordered probit analysis of a panel of firms from 1978 through 1995 suggests that rating standards have indeed become more stringent, implying that at least part of the downward trend in ratings is the result of changing standards. BOND RATINGS PLAY A KEY ROLE in corporate financing and investment decisions. A corporation that can issue higher rated bonds usually receives better terms than one that can issue only lower rated bonds. By law or policy, some investors can purchase only bonds with an investment-grade rating, a restriction which in some asset pricing models would affect the relative prices of financial assets. Numerous articles in the popular press have presumed that the credit quality of the debt of U.S. corporations has been declining over the last couple of decades. The comprehensive study by Lucas and Lonski (1992) of Moody's rating changes of corporate debt is consistent with this presumption. To cite their statistics, in 1970 Moody's downgraded 21 issues and upgraded 23 issues, but over the following years the number of bonds downgraded began to exceed by substantial margins the number of bonds upgraded, and by 1990 Moody's downgraded 301 issues and upgraded only 61. Their study includes both investment and noninvestment grade bonds, but internal data from Donaldson Lufkin & Jenrette confirm that this trend also applies to investment grade bonds alone. In a somewhat different context, Grundy (1997) documents similar trends in the ratings of preferred shares over the 1965 to 1990 period. As the credit quality of a firm's corporate debt decreases, that firm will face a greater probability of financial distress, which at the extreme translates into bankruptcy. There is some debate as to the effect of financial dis

Abstract: In this article we study the effects of transaction costs on asset prices. We assume an overlapping generations economy with a riskless, liquid bond, and many risky stocks carrying proportional transaction costs. We obtain stock prices and turnover in closed form. Surprisingly, a stock's price may increase in transaction costs, and a more frequently traded stock may be less adversely affected by an increase in transaction costs. Calculations based on the 'marginal' investor overestimate the effects of transaction costs. For realistic parameter values, transaction costs have very small effects on stock prices but large effects on turnover.

Abstract: This paper reviews the behavior of financial asset prices in relation to consumption. The paper lists some important stylized facts that characterize US data, and relates them to recent developments in equilibrium asset pricing theory. Data from other countries are examined to see which features of the US experience apply more generally. The paper argues that to make sense of asset market behavior one needs a model in which the market price of risk is high, time-varying, and correlated with the state of the economy. Models that have this feature, including models with habit-formation in utility, heterogeneous investors, and irrational expectations, are discussed. The main focus is on stock returns and short-term real interest rates, but bond returns are also considered.

Abstract: Both bond rating agencies and stock analysts evaluate publicly traded companies and com? municate their opinions to investors. Comparing the timeliness of each, we find that Granger causality flows both ways. While most bond downgrades are preceded by declines in actual and forecast earnings, both actual earnings and forecasts of future earnings tend to fall following downgrades. Although part of this post-downgrade forecast revision can be attributed to negative news regarding actual earnings, most appears to be reaction to the downgrade itself. We find little change in actual earnings following upgrades. Analysts, however, tend to increase their forecasts of future earnings.

Abstract: In this paper we analyze data on nearly 1,000 developing-country bonds issued in the years 1991-96 the recent episode of heavy reliance on bonded debt. We analyze both the issue decision of debtors and the pricing decision of investors, minimizing selectivity bias by treating the two issues jointly. Overall, the results confirm that higher credit quality translates into a higher probability of issue and a lower spread. Importantly, however, we find that observed changes in fundamentals explain only a fraction of the spread compression in the period leading up to the recent crisis in emerging markets.

Abstract: This paper examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's [1994] closed- form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. Short term debt reduces or eliminates "asset substitution" agency cost. The tax advantage of debt must be balanced against bankruptcy and agency cost in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to those found empirically by Sarig and Warga [1989]. The model has important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for "junk" bonds. Furthermore, the "convexity" of bond prices can become "concavity".

Abstract: A unit-linked life insurance contract is a contract where the insurance benefits depend on the price of some specific traded stocks. We consider a model describing the uncertainty of the financial market and a portfolio of insured individuals simultaneously. Due to incompleteness the insurance claims cannot be hedged completely by trading stocks and bonds only, leaving some risk to the insurer. The theory of risk-minimization is briefly reviewed and applied after a change of measure. Risk-minimizing trading strategies and the associated intrinsic risk processes are determined for different types of unit-linked contracts. By extending the model to the situation where certain reinsurance contracts on the insured lives are traded, the direct insurer can eliminate the risk completely. The corresponding self-financing strategies are determined.

Abstract: In this article we discuss a scoring system (EMS model) for emerging markets corporate bonds. The scoring system provides an empirically based tool for the investor to use in making relative value determinations. The EMS model is an enhanced version of the statistically proven Z-score model (Altman, 1968) designed for US companies. Unlike the original Z-score model, our approach can be applied to non-manufacturing companies and manufacturers, and is relevant for privately held and publicly owned firms. The adjusted EMS model incorporates the particular credit characteristics of emerging markets companies, and is best suited for assessing relative value among emerging markets credits. The EMS model combines fundamental credit analysis and rigorous benchmarks together with analyst-enhanced assessments to reach a modified rating, which can then be compared with agency ratings (if any) and market levels. We have included a summary of Mexican companies for which we have applied the EMS model.

Abstract: We examine the predictable components of returns on stocks, bonds, and real estate investment trusts (REITs). We employ a multiple beta asset pricing model and find that there are varying degrees of predictability among stocks, bonds, and REITs. Furthermore, we find that most of the predictability of returns is associated with the economic variables employed in the asset pricing model. The stock market risk premium is highly important in capturing the predictable variation in stock portfolios, the bond market risk premiums (term and risk structure of interest rates) are important in capturing the predictable variation in bond portfolios. For REITs, however, both the stock and bond market risk premiums capture the predictable variation in returns. REITs have comparable return predictability to stock portfolios. We conclude that there is an important economic risk premium for REITs that are not captured by traditional multiple-beta asset pricing models.

Abstract: We assume that the instantaneous riskless rate reverts toward a central tendency which, in turn, is changing stochastically over time. As a result, current short-term rates are not sufficient to predict future short-term rate movements, as it would be the case if the central tendency were constant. However, since longer maturity bond prices incorporate information about the central tendency, longer maturity bond yields can be used to predict future short-term rate movements. We develop a two-factor model of the term structure which implies that a linear combination of any two rates can be used as a proxy for the central tendency. Based on this central-tendency proxy, we estimate a model of the one-month rate that performs better than models which assume the central tendency to be constant.

Abstract: We examine the predictable components of returns on stocks, bonds, and real estate investment trusts (REITs). We employ a multiple-beta asset pricing model and find that there are varying degrees of predictability among stocks, bonds, and REITs. Furthermore, we find that most of the predictability of returns is associated with the economic variables employed in the asset pricing model. The stock market risk premium is highly important in capturing the predictable variation in stock portfolios, and the bond market risk premiums (term and risk structure of interest rates) are important in capturing the predictable variation in bond portfolios. For REITs, however, both the stock and bond market risk premiums capture the predictable variation in returns. REITs have comparable return predictability to stock portfolios. We conclude that there is an important economic risk premium for REITs that are not captured by traditional multiple-beta asset pricing models.

Abstract: Bond ratings are usually first assigned by rating agencies to public debt at the time of issuance and are periodically reviewed by the rating companies. If deemed warranted, changes in ratings are assigned after the review. A change in a rating reflects the agency’s assessment that the company’s credit quality has improved (upgrade) or deteriorated (downgrade). A coincident effect, in some proximity to the date of the rating change, is a change in the price of the issue. This article reports on an in-depth investigation of the expected ratings changes (drift) over time. Our analysis compares rating changes from the two major agencies, Moody’s and S&P, over the period 1970–1996. For the first time, results from several studies which have documented and analyzed these data patterns are contrasted. Depending upon which study one uses, the results and implications can be very different. We expect that the findings will have implications for such diverse practitioners as bond investors who concentrate on any or all segments of the corporate bond market, eg., high yield bond and “crossover” investors, mark-to-market analysts, and traders in the new and growing market for credit-risk-derivatives and for the many analysts who properly view that credit quality assessment involves the entire spectrum of possible outcomes, not just default. A follow-up study will analyze, in greater depth, two critical characteristics of the rating drift phenomenon. These are unexpected, as well as expected, rating migration patterns and also the implied impact on the price of the fixed income instrument.

Abstract: This paper investigates the commonly held belief that government spending is normally financed through a combination of taxes and bond sales. The argument is a technical one and requires a detailed analysis of reserve accounting at the central bank. After carefully considering the complexities of reserve accounting, it is argued that the proceeds from taxation and bond sales are technically incapable of financing government spending and that modern governments actually finance all of their spending through the direct creation of high-powered money. The analysis carries significant implications for fiscal as well as monetary policy.

Abstract: Many advocates of social security privatization argue that rates of return under a defined contribution individual account system would be much higher for all than they are under the current social security system. This claim is false. The mistake comes from ignoring accrued benefits already promised based on past payroll taxes, and from underestimating the riskiness of stock investments. Confusion arises because three distinct reforms are muddled. By privatization we mean creating individual accounts (which could, for example, be invested exclusively in bonds). By diversification we mean investing in stocks, and perhaps other assets, as well as bonds; diversification might be undertaken either by individuals in their private social security accounts, or by the social security trust fund. By prefunding we mean closing the gap between social security benefits promised to date and the assets on hand to pay for them. Any one of these reforms could be implemented without the other two. If the system were completely privatized, with no prefunding or diversification, the social security system would need to raise taxes and/or issue new debt in order to pay benefits already accrued. If the burden were spread evenly across all future generations via a constant proportional tax, the added taxes would completely eliminate any rate of return advantage on the individual accounts. We estimate that the required new taxes would amount to about 3 percent of payroll, or about a quarter of all social security contributions, in perpetuity. Unlike privatization, prefunding would raise rates of return for later generations, but at the cost of lower returns for today's workers. For households able to invest in the stock market on their own, diversification would not raise rates of return, correctly adjusted to recognize risk. Households that are constrained from holding stock, due to lack of wealth outside of social security or to fixed costs from holding stocks, would gain higher risk-adjusted returns and would benefit from diversification. If this group is large, diversification would raise stock values, thus helping current stockholders, but it would lower future stock returns, thus hurting young unconstrained households. Overall, since the number of truly constrained household is probably not that large, privatization and diversification would have a much smaller effect on returns than reformers typically claim.

Abstract: A split bond rating occurs when Moody's and Standard & Poor give different ratings to the same issue. We examine 1,277 public industrial bond issues, where 221 have split ratings, issued from 1980 through mid-1993. For split-rated industrial bonds, neither rating agency consistently gives higher ratings. Earlier studies find yields for split-rated bonds to be priced as either the higher or the lower of the ratings. We find the yields on split-rated bonds to be an average of the yields on the two ratings. Split ratings for industrial bonds appear to reflect random differences on the part of rating agencies. Our results differ from previous studies because we use a substantially larger sample and include high-yield bonds. As long as a bond has an investment-grade rating, the underwriter fees are found to be essentially the same for all rating categories. Below investment grade, the rating substantially affects the underwriter fee. Thus, split ratings for high-yield bonds have an important effect on the underwriter spread.

Abstract: NOTE: The following is a description of the paper and is not the "actual" abstract. This article examines the nature of volatility linkages in an economy with multiple securities markets. The analysis is based on the relation between volatility and information flow. To formalize this relation, we develop a simple model of speculative trading where the traders take positions in one or more futures contracts based on their current expectations and their risk tolerances. As new information is released, they update their expectations, revise their demands, and trade accordingly. Under the model, information generates market linkages in two ways. First, information can simultaneously affect expectations about the risk and return characteristics of multiple contracts (i.e., the information is common across markets). Second, information can directly affect expectations in only one market but impact other markets through hedging demand (i.e., there is an information spillover between markets). In frictionless markets, the model predicts that hedging causes complete information spillover, leading to perfectly correlated volatility changes across markets. In practice, however, institutional factors and market frictions will limit the impact of cross-market hedging and preclude complete spillover. As a result, the model predicts strong volatility linkages in markets where the hedging benefits are large and the hedging costs are small. We use a stochastic volatility representation of the model to estimate the volatility linkages for three futures markets where we expect both common information and information spillover to be important: the stock, bond, and money markets. The results are generally supportive of our model. The time-series properties of returns are similar to those predicted by the model and the volatility linkages between markets are strong. In addition, subperiod analysis suggests the strength of the linkages increased substantially following the 1987 stock market crash.

Abstract: In the 1990s international bond issues from developing countries surged dramatically, becoming one of the fastest-growing devices for financing external development. Their terms have improved as institutional investors have become more interested in emerging market securities and better economic prospects in a number of developing countries. But little is known about what determines the pricing and thus the yield spreads of new emerging market bond issues. The author investigates what determines bond spreads in emerging markets in the 1990s. He finds that strong macroeconomic fundamentals in a country -- such as low domestic inflation rates, improved terms of trade, and increased foreign assets -- are associated with lower yield spreads. By contrast, higher yield spreads are associated with weak liquidity variables in a country, such as a high debt-to-GDP (Gross Domestic Product) ratio, a low ratio of foreign reserves to GDP, a low (high) export (import) growth rate, and a high debt-service ratio. At the same time, external shocks -- as measured by the international interest rate -- matter little in the determination of bond spreads. In the aggregate, Latin America countries have a negative yield curve.

Abstract: A variety of realistic economic considerations make jump- diffusion models of interest rate dynamics an appealing modeling choice to price interest rate contingent claims. However, exact closed form solutions for bond prices when interest rates follow a mixed jump-diffusion process have proved very hard to derive. This paper puts forward two new models of interest rate dynamics which combine infrequent, discrete changes in the interest rate level, modeled as a jump process, with short lived, mean reverting shocks, modeled as a diffusion process. The two models differ in the way jumps affect the central tendency of interest rates; in one case shocks are temporary, in the other shocks are permanent. We derive exact closed form solutions for the price of a discount bond, and computationally tractable schemes to price bond options.

Abstract: This paper describes how three money’s worth measures – the benefit-to-tax ratio, the internal rate of return, and the net present value – are calculated and used in analyses of social security reforms, including systems with privately managed individual accounts invested in equities. Declining returns from the U.S. social security system prove to be the inevitable result of having instituted an unfunded (pay-as-you-go) retirement system that delivered $7.9 trillion of net transfers (in 1997 present value dollars) to people born before 1917, and will deliver another $1.8 trillion to people born between 1918 and 1937. But young and future workers cannot necessarily do better by investing their payroll taxes in capital markets. If the old system were closed down, massive unfunded liabilities of $9-10 trillion would still have to be paid unless already accrued benefits were cut. Alternative methods of calculating these accrued benefits yield somewhat different numbers: the straight line calculation is $800 billion less than the constant benefit calculation we propose as the benchmark. Using this benchmark in a world with no uncertainty, we show that privatization without prefunding would not increase returns at all, net of the new taxes needed to pay for unfunded liabilities. These new taxes would amount to 3.6 percent of payroll, or about 29 percent of social security contributions. Prefunding, implemented by reducing accrued benefits or by raising taxes, would eventually increase money’s worth for later generations, but at the cost of lower money’s worth for today’s workers and/or retirees. Computing money’s worth when there is uncertainty is much more difficult unless four conditions hold, namely optimization, time homogeneity, stable prices, and spanning. Under these conditions, the diversification of social security investments into stocks and out of bonds has no effect whatsoever on money’s worth when it is properly adjusted for risk: a dollar of stock is worth no more than a dollar of bonds. When spanning fails, diversification can raise welfare for constrained households, but the exact money’s worth must depend on specific assumptions about household attitudes toward risk. Calculations like those of the Social Security Advisory Council that attribute over $2.85 of net present value gain to each $1 shifted from bonds to stocks completely overlook the disutility of risk. By contrast, we estimate that a 2 percent of payroll equity fund carved out of social security would increase net present value by about 59 cents per dollar of bonds switched into equities, instead of $2.85. When the likely reductions in income and longevity insurance are factored in, the net advantage of privatization and diversification is substantially less than popularly perceived.

Abstract: On the eve of a major change in the world monetary system, the adoption of a single currency in Europe, our theoretical understanding of the implications of the exchange rate regime for trade and capital flows is still limited. We argue that two key model ingredients are essential to address this question: a general equilibrium setup and deviations from purchasing power parity. By developing a simple benchmark monetary model that contains these two ingredients, we find the following main results. First, the level of trade is not necessarily higher under a fixed exchange rate regime. Second, the level of net capital flows tends to be higher under a fixed exchange rate regime when there is a preference for domestic bonds, which is the case when the rate of relative risk-aversion is larger than one. Third, the asset market structure, including the presence of a forward market, does not quantitatively affect the results.

Abstract: The turn-of-the-year (or January) effect is persuasive and well-documented anomaly in the financial markets. This paper examines this effect in the corporate bond market and documents a strong January effect in both the yield and the returns of corporate bonds. The paper investigates the underlying factors and finds that the January effect is a function of several factors that coincide around the turn of the year.

Abstract: The term structure of interest rates, i.e., the yield curve, has long been of interest to monetary policymakers and their advisers. The transmission of monetary policy is conventionally viewed as running from shortterm interest rates managed by central banks to longer-term rates that influence aggregate demand. A central bank's leverage over longer-term rates comes from the fact that the market determines these as the average expected level of short rates over the relevant horizon (abstracting from a term premium and default risk). Working in the other direction, the long bond rate contains a premium for expected inflation and, thus, serves as an indicator of the credibility of a central bank's commitment to low inflation.1 Different theoretical perspectives support the two above-mentioned uses of the term structure for monetary policy: John Hicks's (1939) expectations theory of the term structure supports the first, and Irving Fisher's (1896) decomposition of nominal bond rates into expected inflation and an expected real return supports the second.2 The two views are compatible in principle, although reconciling them creates difficulties of interpretation in practice. For example, does a steepening yield curve indicate a loss of confidence in the central bank's commitment to low inflation, or does it indicate that markets expect tighter policy in the form of a higher path of short rates pursued by the central bank? The yield curve contains information of use to monetary policymakers, but it needs to be interpreted in light of judicious subsidiary "identifying" conditions, together with other data on the economy. Some circumstances lend themselves to clearer interpretations than others, and there are many pitfalls. Whether or not one regards longer-term interest rates as economic indicators or as part of the transmission mechanism for policy, or both, the term structure plays a potentially important role in the policymaking process. In spite of its complexity, the term structure cannot be ignored. This article addresses some issues involved in using the term structure to conduct monetary policy. I begin by discussing the long bond rate as an indicator of inflation expectations. Second, I comment on the role that bond rates have played in recent U.S. monetary history. Third, I explain how information in the yield curve can be used to overcome what I call the "policy in the pipeline problem." Fourth, I review recent empirical evidence supporting the two theoretical views underlying our understanding of the term structure. I explain how "peso problems" associated with "inflation scares" in the bond market may help to account for a serious empirical failure of the expectations theory of the term structure. I also discuss evidence supporting the view that significant movements in long-term interest rates are largely driven by expected inflation. Finally, I point out some pitfalls of using the term structure to make tactical policy decisions. 1. PURSUING LOW INFLATION The Chairman of the Federal Reserve Board, Alan Greenspan, supports a longrun goal for price stability such that "the expected rate of change of the general level of prices ceases to be a factor in individual and business decisionmaking."3 The long bond rate is particularly well suited to help a central bank assess the degree to which it has achieved low inflation defined in that way. One could compare the behavior of the yield on a long-term nominal bond to its behavior in a past period in which inflation was very low and the public was reasonably confident that it would stay low. For instance, in the United States the 30-year nominal bond rate ranged from around 3 percent to a little over 4 percent from the mid-1950s until the mid-1960s, a period in which inflation averaged around 1 to 2 percent, and presumably, long-term inflation expectations were no more than that.4 One would think that if the Federal Reserve (the Fed) were to achieve full credibility for low inflation, the long bond rate would once again move down to the 3 to 4 percent range. …

Abstract: A method and apparatus for enhancing the stock of a business entity by joining the shares of stock to non-investment bonds at no cost, no loss financially to any current and/or future shareowner with any principal or issue price is zero, unpaid or paid by any means other than any current and/or future shareowner paying any money or property for the bonds. The enhancement that is derived from this joining is called a Share Bond (28) which has increased investment security, guaranteed monetary benefits for the shareowners that are administered by the data processing system provided by the invention. This includes the joining, updating of information, calculating payments and distribution of the Share Bond benefits.

Abstract: This paper generalizes the stochastic duration concept of Cox, Ingersoll, and Ross (1979) to multi-factor diffusion models of the term structure of interest rates. The stochastic duration has time as its unit and measures the sensitivity of the price of a bond (or portfolio of bonds) with respect to any change of the term structure consistent with the model. Some important general properties of the stochastic duration measure are given. For example, it is proven that, under conditions satisfied by most popular term structure models, the familiar Fisher-Weil duration overestimates the interest rate risk of coupon bonds. The stochastic duration is studied in detail in various well-known models. It is also shown that the price of a European option on a coupon bond can be approximated very accurately by a multiple of the price of a European option on a zero-coupon bond with a time to maturity equal to the stochastic duration of the coupon bond. This provides a fast method for pricing European swaptions in multi-factor models.

Abstract: A two-stage estimation procedure is employed to evaluate non-bank financial institution efficiency. In the first stage, maximum-likelihood estimates of an econometric cost function are obtained for a cross-section of 150 Australian credit unions. The results indicate that a typical credit union's costs in 1995 were only some 7% above what could be considered efficient. The second stage uses limited dependent variable regression techniques to relate credit union efficiency scores to structural and institutional considerations. The results indicate that non-core commercial activities are not a significant influence on the level of cost inefficiency, although asset size, capital adequacy regulation, and branch and agency networks are significant. A primary influence on credit union efficiency would appear to be the industrial or community associational bond under which they were created, and to a lesser extent the state-based regulatory framework.

Abstract: Non-investment-grade debt offerings have a reputation as “story bonds” for which objective valuation criteria are difficult to establish. Nevertheless, 56 percent of the variance in risk premiums is explained by quantifiable factors, such as rating, term, and secondary-market spreads. At the same time, the underwriter's effectiveness in presenting the issuer to investors appears to materially influence pricing.