Manager Characteristics and Credit Derivative Use by U.S. Corporate Bond Funds

Abstract:

This study provides a comprehensive overview of the use of credit default swaps by U.S. corporate bond funds and analyzes in detail whether certain characteristics of managers, in addition to the fundamentals of a fund, determine how their use these credit derivatives. Results suggest that a manager’s education, age, experience, and skill are positively correlated with a fund’s CDS holdings. In particular, managers holding a master’s degree or educated at prestigious universities prefer using CDS. However, funds with older, more experienced managers or these keeping higher assets under their management are more likely to take on credit risk via selling CDS protection. Younger managers or managers that were educated at prestigious universities rather tend to buy CDS protection possibly due to differing concerns about their careers. If considering the Heckman correction for self-selection of funds into CDS use, the aforementioned findings remain stable.

 

JEL Classification: G23, G28

Keywords: Manager, manager characteristic, mutual fund, derivative use, credit default swap

 

Full text in pdf format:

495.pdf

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Loss Potential and Disclosures Related to Credit Derivatives – A Cross-Country Comparison of Corporate Bond Funds under U.S. and German Regulation

Abstract:

This study analyzes the loss potential arising from investments into CDS for a sample of large U.S. and German mutual funds. Further, it investigates whether the comments funds make on CDS use in periodic fund reports are consistent with the disclosed CDS holdings. For several funds in the U.S., the potential losses arising from selling CDS protection are almost as high as net assets, while in Germany, this potential can be even higher. Regarding the information funds provide to investors about their use of CDS, the results of the study suggest that comments on CDS contained in periodic reports are often unspecific and sometimes misleading. Thus, investors might have to analyze portfolio holdings in order to learn about the true investment behavior of funds. For instance, in Germany, funds that use more short than long CDS often state that they only use long CDS for hedging purposes. Based on the results, it seems advisable that regulators in both countries tighten rules restricting the speculative use of derivatives by funds to a reasonable level, as well as implement more standardized disclosure policies.

 

JEL-Classification: G11, G15, G23, G28

Keywords: Mutual funds, leverage, derivative, credit default swaps, disclosure

 

Full text in pdf format:

494.pdf

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Re-Mapping Credit Ratings

Abstract:

Rating agencies report ordinal ratings in discrete classes. We question the market’s implicit assumption that agencies define their classes on identical scales, e.g., that AAA by Standard & Poor’s is equivalent to Aaa by Moody’s. To this end, we develop a non-parametric method to estimate the relation between rating scales for pairs of raters. For every rating class of one rater this, scale relation identifies the extent to which it corresponds to any rating class of another rater, and hence enables a rating-class specific re-mapping of one agency’s ratings to another’s. Our method is based purely on ordinal co-ratings to obviate error-prone estimation of default probabilities and the disputable assumptions involved in treating ratings as metric data. It estimates all rating classes’ relations from a pair of raters jointly, and thus exploits the information content from ordinality.

 

We find evidence against the presumption of identical scales for the three major rating agencies Fitch, Moody’s and Standard & Poor’s, provide the relations of their rating classes and illustrate the importance of correcting for scale relations in benchmarking.

 

Key words: credit rating, rating agencies, rating scales, comparison of ratings

JEL: C14, G24

Full text in pdf format:

492.pdf

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Innovation strategies and stock price informativeness

Abstract:

This paper models the interactions among technological innovation, product market competition and information leakage via the stock market. There are two firms who compete in a product market and have an opportunity to invest in a risky technology either early on as a leader or later once stock prices reveal the value of the technology. Information leakage thus introduces an option of waiting, which enhances production efficiency. A potential leader may nevertheless be discouraged from investing upfront, when anticipating its competitor to invest later in response to good news. I show that an increase in product market competition increases the option value of waiting but has an ambiguous effect on information production. It may thus be the case that intense competition leads to more leakage such that no firm would invest, especially so in a smaller market. Given a moderate level of competition, price informativeness may also improve investment outcome when investment profitability and the market size are relatively large. The model predicts that, under these conditions, the investment of a follower firm is more sensitive to share price movements.

 

JEL Classification Code: G14, G31, D43

Keywords: Price efficiency; Information leakage; Innovation; Feedback

Full text in pdf format:

491.pdf

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The Impact of Credit Default Swap Trading on Loan Syndication

Abstract:

We analyze the impact of CDS trading on bank syndication activity. Theoretically, the effect of CDS trading is ambiguous: on the one hand, CDS can improve risk-sharing and hence be a more flexible risk management tool than loan syndication; on the other hand, CDS trading can reduce bank monitoring incentives. We document that banks are less likely to syndicate loans and retain a larger loan fraction once CDS are actively traded on the borrower’s debt. We then discern the risk management and the moral hazard channel. We find no evidence that the reduced likelihood to syndicate loans is a result of increased moral hazard problems.

 

Keywords: Loan Sales, Credit Default Swaps, Syndicate Structure, Syndicated Loans

JEL-Classification: G21, G32

Full text in pdf format:

490.pdf

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The Total Costs of Corporate Borrowing in the Loan Market: Don’t Ignore the Fees

Abstract:

More than 80% of US syndicated loans contain at least one fee type and contracts typically specify a menu of spread and different types of fees. We test the predictions of existing theories about the main purposes of fees and provide supporting evidence that: (1) fees are used to price options embedded in loan contracts such as the draw-down option for credit lines and the cancellation option in term loans; and (2) fees are used to screen borrowers about the likelihood of exercising these options. We also propose a new total-cost-of-borrowing measure that includes various fees charged by lenders.

 

Full text in pdf format:

489.pdf

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Does contingent capital induce excessive risk-taking?

Abstract:

In this paper, we analyze the effect of the conversion price of CoCo bonds on equity holders' incentives. First, we use an option-pricing context to show that CoCo bonds can magnify equity holders' incentives to increase the riskiness of assets and decrease incentives to raise new equity in a crisis in cases in which conversion transfers wealth from CoCo bond holders to equity holders. Second, we present a clinical study of the CoCo bonds issued so far. We show that i) almost all existing CoCo bonds are designed in a way that implies a wealth transfer from CoCo bond holders to equity holders at conversion and ii) this contractual design is reflected in traded prices of CoCo bonds. In particular, CoCo bonds are short volatility with a magnitude five times greater than that which can be observed for straight bonds. These results are robust and economically significant. We conclude that the CoCo bonds issued so far can create perverse incentives for banks' equity holders.

 

Keywords: Contingent capital, banking regulation, risk-taking incentives, asset substitution, debt overhang, credit crunch

 

Full text in pdf format:

488.pdf

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Hold-Up and the Use of Performance-Sensitive Debt

Abstract:

We examine whether performance-sensitive debt (PSD) is used to reduce hold-up problems in long-term lending relationships. We find that the use of PSD is more common in the presence of a long-term lending relationship and if the borrower has fewer financing alternatives available. In syndicated deals, however, the presence of a relationship lead arranger reduces the use of PSD, which is consistent with hold-up being of lesser concern in such cases. Further, supporting our hypothesis that hold-up concerns motivate the use of PSD, we find a substitution effect between the use of PSD and the tightness of financial covenants.

 

Keywords: Performance-sensitive debt, relationship lending, hold-up, holdout, syndicated debt, covenants

JEL-Classification: G21, G31, G32

Full text in pdf format:

476.pdf

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Managerial Optimism and Debt Contract Design: The Case of Syndicated Loans

Abstract:

We examine the impact of managerial optimism on the inclusion of performance-pricing provisions in syndicated loan contracts (PSD). Optimistic managers may view PSD as a relatively cheap form of financing given their upwardly biased expectations about the firm’s future cash flow. Indeed, we find that optimistic managers are more likely to issue PSD, and choose contracts with greater performance-pricing sensitivity than rational managers. Consistent with their biased expectations,

firms with optimistic managers perform worse than firms with rational managers after issuing PSD. Our results indicate that behavioral aspects can affect contract design in the market for syndicated loans.

 

Keywords: Optimism Bias, Performance-Sensitive Debt, Debt Contracting, Syndicated

Loans

JEL-Classification: G02, G30, G31, G32

Full text in pdf format:

475.pdf

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Similarities and Differences between U.S. and German Regulation of the Use of Derivatives and Leverage by Mutual Funds – What Can Regulators Learn from Each Other?

Abstract:

This study analyzes current regulation with respect to the use of derivatives and leverage by mutual funds in the U.S. and Germany. After presenting a detailed overview of U.S. and German regulations, this study thoroughly compares the level of flexibility funds have in both countries. I find that funds in the U.S. and Germany face limits on direct leverage (amount of bank borrowing) of up to 33% and 10% of their net assets, respectively. Funds can extend these limits indirectly by using derivatives beyond their net assets (e.g., by selling credit default swaps protection with a notional amount equal to their net assets). Additionally, issuer-oriented rules in the U.S. and Germany account for issuer risk differently: U.S. funds have greater discretion to undervalue derivative exposure compared to German funds. All analyses of this study reveal that under existing derivative and leverage regulation, funds in both countries are able to increase risk by using derivatives up to the point at which it is possible for them to default solely due to investments in derivatives. The results of this study are highly relevant for the public and regulators.

 

JEL-Classification: G15, G18

Key Words: Regulation, mutual funds, leverage, derivative, credit default swaps

Full text in pdf format:

474.pdf

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