Why Are Yield Spreads on BankIssued Subordinated Notes and
Debentures Not Sensitive to Bank
Risks?
Bhanu Balasubramnian
Emporia State University
Ken Cyree
The University of Mississippi
Debt Market Signals
• Yield Spread = f (Term-structure, Default risk, Maturity
Risk, Taxes, Liquidity Risk, Systematic Risk,
Unknown factors)
• Yield Spread on Bonds = YTM of a risky bond - YTM
of a risk-free bond of similar characteristics
• When leverage (or any other risk measure) decreases,
default risk decreases. In turn, yield spread should
decrease and vice versa
• Change in yield spreads acts as signal for market
perception of change in firm risk or default risk
Debt Market Signals – Empirical Evidence
• SND spreads are less risk sensitive during the 1993-97
period and market discipline is weak - Board of Governors (1999)
• Changes in yield spreads are not related to changes in
firm-specific risk of banks during 1994-99 - Krishnan, Ritchken,
and Thomson (2005)
• Default risk component is large in money-market
securities– Covitz and Downing (2007)
• Are the long-term debt markets sensitive to all non-credit
risks but not sensitive to credit risks?
Research Questions
• Is lack of default risk sensitivity due to omitted credit risk
factors?
– Omitted factors of credit risk
– Trust-Preferred Securities (TPS)
– Too Big To Fail (TBTF) effect after LTCM crisis
– Idiosyncratic Volatility
– Omitted factors in decomposition of yield spreads
– Tax effects – Elton, Gruber, Agrawal, and Mann (2001)
• Whether or not TPS yield spreads can be used for market
monitoring?
Data Sources
• National Association of Insurance
Commissioners (NAIC) database for bond
transactions for the years 1994 – 1999
• SDC Platinum database - bond issue
characteristics
• FR Y-9C reports for banks
• CRSP for stock market data
• H-15 Reports from St. Louis Fed for daily
Treasury rates
Sample Selection
• Select fixed-rate, U.S. dollar, plain-vanilla
bonds with investment grade credit ratings
• No put or call options, collateral, sinking fund
• Should not be convertible, Yankee, global,
serial, LBO
• Only bank-issued SND transactions
• With at least two years of remaining maturity
• At least 10 transactions per SND issue
• 6620 buys and 4072 sell transactions
• 300 SND issues by 71 BHCs
Decomposition of Yield Spreads
YS (i, t) = α + β (F, k) F (i, t-1) + β (M, k) M( t) + β
(L, k) L( t) + β (X, k) X (i, t) + ε (i, t)
(1)
•
•
•
•
•
•
YS (i, t) = Yield spread of bond i at time t
F (i, t-1) = Vector of firm-level default risk variables
M (t) = Vector of market variables
L (t) = Vector of liquidity variables
X (i, t) = Vector of other control variables
Non-linear GMM estimation with Newey -West
(1987) correction for autocorrelation and
heteroskedasticity with five lags
Table 4: Firm Specific Variables reflect default risks except ROA
Variable
Estimate
p-value
Loans / Total assets (LTA) %
0.4551
0.0001
Non-performing loans / Total loans (NPA) %
7.2025
<.0001
-9.2037
0.2752
Commercial loans / Total loans (CNI) %
0.2973
0.0038
Off-bal. sheet items / Total assets (OFFBAL) %
0.0200
0.0010
Log (Total Assets) (LNTA) %
-0.1130
<.0001
Total Assets / Total Equity (LEVERAGE) %
0.1883
0.0179
Return on Assets (ROA) %
7.6095
0.0198
-0.0853
<.0001
0.8886
0.0116
Net charge-off / Loans (CHGOFF) %
Market value / Book value (MB) %
Std. Dev. of stock returns (VOLATILITY) %
Results – Full Sample
• Yield Spread Levels are sensitive to firmspecific default risk variables
• Tax Effects are significant
• Idiosyncratic volatility measure (σ) captures
default risks better than Market volatility
measure (VIX)
• Discount for size – TBTF discount
• Exception - ROA is positively related to yield
spreads
LTCM Crisis and TBTF Effect
• January 1994 - June 1998 -Pre-LTCM bailout
period
• July 1998 – December 1999- Post-LTCM
period
• Important dates – July 20, 1998, Aug 17, 1998,
September 02, 1998, September 24, 1998
• Major Crises - Mexican (Dec 94), Asian
(June 97), Russian and LTCM (Aug 98),
Brazilian (Nov 98)
Paradigm Shift in Firm-specific Default
Risk Proxies and TBTF Effect
Table 5: Panel C: Firm Specific Variables
Variable
Pre-LTCM Crisis
Post-LTCM Crisis
Estimate
p-value
31.7902
0.0076
25.5631
0.3441
Non-per. loans / Total loans (NPA)
475.4882
0.0007
1759.2530
0.0215
Net charge-off / Loans (CHGOFF)
123.5340
0.8924
2764.0580
0.1512
15.9458
0.1346
32.4829
0.1587
0.9969
0.1596
2.5581
0.0072
Log (Total Assets) (LNTA)
-11.3074
<.0001
-23.2922
<.0001
Assets / Equity (LEVERAGE)
20.5950
0.0118
8.0460
0.6849
277.3742
0.4406
1938.2410
0.0193
Market value / Book value (MB)
-6.5626
0.0004
-8.7271
0.0033
Std. Dev. of returns (VOLATILITY)
94.8226
0.0570
-60.8598
0.2945
Loans / Total assets (LTA)
Commercial loans / Total loans (CNI)
Off-bal. items / Total assets (OFFBAL)
Return on Assets (ROA)
Estimate
p-value
Default Risk Reduction Due to TPS
• SND issued by all banks as at the end of 1998
$102.8 billion, of which, $100 billion was
issued by the top 50 banks
• TPS is the least expensive source of external
Tier 1 capital
• Over 800 banks have issued TPS for a total of
$85 billion between 1996 and 2004; $28
billion between 1996 and 1999 by the top 50
banks
Leverage is not a significant determinant of yield spread
even prior to LTCM bailout but after TPS issuance
Variable
Pre-TPS
Estimate
Post-TPS pre-LTCM
p-value
Estimate
p-value
Post-TPS post-LTCM
Estimate
p-value
LTA
52.1058
0.0005
64.7671
0.0467
13.7311
0.6362
NPA
452.8539
0.0019
262.9285
0.6540
2270.5670
0.0234
-714.7270
0.5415
-1001.8100
0.6388
2617.7570
0.2406
CNI
2.0294
0.8867
44.9515
0.1169
40.3863
0.1372
OFFBAL
1.3892
0.1068
-0.3551
0.8322
2.3734
0.0153
-14.8392
<.0001
-12.4138
0.0357
-28.3796
<.0001
35.7267
0.0008
27.3064
0.1117
-3.1101
0.8850
1082.2780
0.0178
548.6316
0.5427
2215.3660
0.0125
-18.4576
<.0001
-5.8614
0.0717
-8.1716
0.0118
-8.2015
0.9096
193.7806
0.0062
-28.9854
0.6205
CHGOFF)
LNTA
LEVERAGE
ROA
MB
VOLATILITY
TPS Spreads are sensitive to on-balance sheet default
risk proxies
Variable
Estimate
p-value
415.37
0.0648
10405.00
0.0646
Off-balance sheet items / Total assets (OFFBAL)
-2.08
0.4007
Log (Total Assets) (LNTA)
-5.02
0.5397
Total Assets / Total Equity (LEVERAGE)
91.22
0.0128
-4087.45
0.0521
Intercept
Net charge-off / Loans (CHGOFF)
Return on Assets (ROA)
No. of observations
58
Adj. R-Sq.
F-Statistics
0.5238
5.18
<.0001
Changes in Determinants of Yield Spreads
• To trace the changes in determinants of yield
spreads – Analyze four sub-periods around
LTCM crisis
• August 97 – February 98 - tranquil period
• March 98 – June 98, the period when bond
market volatility increased
• July 98 – September 98, the period when bond
markets became extremely volatile
• October 98 - December 99, the post-LTCM
bailout period
Leverage is irrelevant; ROA is a risk proxy;
Markets recognize off-balance sheet risks;
TBTF Discount increases
Variable
Aug97-Feb98
Mar98-June98
July98-Sep98
Oct98-Dec99
Estimate
p-value
Estimate
p-value
Estimate
p-value
Estimate
p-value
LTA
0.29
0.3983
1.32
0.1197
0.04
0.9540
0.35
0.2217
NPA
-5.03
0.6505
29.84
0.0190
-9.23
0.5279
21.99
0.0081
CHGOFF
57.53
0.6915
42.45
0.5676
24.01
0.6743
54.06
0.0062
OFFBAL
0.00
0.9975
0.01
0.5653
0.04
0.1916
0.02
0.0407
-0.07
0.4162
-0.15
0.2262
-0.28
0.0695
-0.25
<.0001
LEVERAGE
0.24
0.2974
-0.20
0.6847
-0.71
0.0786
0.34
0.1263
ROA
6.74
0.5700
-15.23
0.0085
-81.11
0.0588
17.80
0.0295
-0.10
0.0193
0.06
0.4068
0.12
0.1480
-0.09
0.0090
1.67
0.0802
1.95
0.0378
0.74
0.6524
-0.32
0.5930
LNTA
MB
VOLATILITY
n94
Ap
r-9
4
Ju
l-9
4
O
ct
-9
4
Ja
n95
Ap
r-9
5
Ju
l-9
5
O
ct
-9
5
Ja
n96
Ap
r-9
6
Ju
l-9
6
O
ct
-9
6
Ja
n97
Ap
r-9
7
Ju
l-9
7
O
ct
-9
7
Ja
n98
Ap
r-9
8
Ju
l-9
8
O
ct
-9
8
Ja
n99
Ap
r-9
9
Ju
l-9
9
O
ct
-9
9
Ja
Yield Spread in basis points
Monthly Average Yield Spread on BBB-rated SND
250.00
200.00
150.00
LTCM
TPS
100.00
50.00
0.00
Month-Year
WSJ 04/17/2008–Ahead of the Tape
Results
• Yield spread levels on SND are sensitive to conventional risk
measures prior to TPS issuance by banks
• Risk sensitivity of conventional risk measures decrease after the
introduction of TPS
• No TBTF effect before the LTCM bailout but size discount
doubles after the LTCM bailout
• Idiosyncratic volatility is a better proxy for firm-specific risks
• Omitting the tax effects in yield spreads leads to measurement
errors
• Yield spreads on TPS provide market signals
Results
• Bond markets are sensitive to default risks,
but paradigm changes in the determinants of
yield spreads after LTCM bailout
• Default risk proxies vary with time and
available information
– Leverage is not a proxy
– ROA is a proxy for changes in risk-taking
– Off-balance sheet items is a proxy
Policy Implications
• Implicit guarantees and market discipline
• Can TPS provide better market signals? –
Needs further investigation after TARP
• Disclosure Levels of off-balance sheet items
• Can TPS and SND be capital securities
without risk of capital loss?
• Risk-weighting of earnings for CAMELS
Thank You
Questions?
Suggestions?