Why Are Yield Spreads on Bank-Issued Subordinated Notes and
Debentures Not Sensitive to Bank Risks?
Bhanu BalasubramnianEmporia State University
Ken CyreeThe 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 SpreadsYS (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
Net charge-off / Loans (CHGOFF) % -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
Market value / Book value (MB) % -0.0853 <.0001
Std. Dev. of stock returns (VOLATILITY) % 0.8886 0.0116
Results – Full Sample
• Yield Spread Levels are sensitive to firm-specific 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
VariablePre-LTCM Crisis Post-LTCM Crisis
Estimate p-value Estimate p-value
Loans / Total assets (LTA) 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
Commercial loans / Total loans (CNI) 15.9458 0.1346 32.4829 0.1587
Off-bal. items / Total assets (OFFBAL) 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
Return on Assets (ROA) 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
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
VariablePre-TPS Post-TPS pre-LTCM Post-TPS post-LTCM
Estimate p-value Estimate p-value 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
CHGOFF) -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
LNTA -14.8392 <.0001 -12.4138 0.0357 -28.3796 <.0001
LEVERAGE 35.7267 0.0008 27.3064 0.1117 -3.1101 0.8850
ROA 1082.2780 0.0178 548.6316 0.5427 2215.3660 0.0125
MB -18.4576 <.0001 -5.8614 0.0717 -8.1716 0.0118
VOLATILITY -8.2015 0.9096 193.7806 0.0062 -28.9854 0.6205
TPS Spreads are sensitive to on-balance sheet default risk proxies
Variable Estimate p-value
Intercept 415.37 0.0648
Net charge-off / Loans (CHGOFF) 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
Return on Assets (ROA) -4087.45 0.0521
No. of observations 58
Adj. R-Sq. 0.5238
F-Statistics 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
VariableAug97-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
LNTA -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
MB -0.10 0.0193 0.06 0.4068 0.12 0.1480 -0.09 0.0090
VOLATILITY 1.67 0.0802 1.95 0.0378 0.74 0.6524 -0.32 0.5930
Monthly Average Yield Spread on BBB-rated SND
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TPS
LTCM
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?