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FRBSF
WEEKLY LETTER
April 10, 1987
Junk Bonds: Why Now?
One of the most visible developments in finance
markets in recent years has been the rapid
growth in the issuance of low~rated bonds to
finance corporate activity. The quarterly volume
of new debt issues with a Moody's rating below
Baa (referred to variously as "noninvestment
grade", "high yield", or "junk" bonds)
amounted to only $380 million as recently as
the first quarter of 1982, but had grown to $11
billioh by the second quarter of 1986. Presently,
junk bond financing represents 20 to 30 percent
of all corporate debt issuance.
The increasing use of junk bonds is the subject
of vigorous public and policymaker debate for a
number of reasons. Some observers are concerned because some of these high yield - and
high risk - bonds are held in the portfolios of
thrift institutions, life insurance companies, and
pension funds where they may put the income
of investors at risk. There is also concern that
junk bonds facilitate corporate takeovers, an
activity that some consider inherently undesirable. Finally, there is the concern that the promised yields of junk bonds will fail to materialize
and that the defaults will reverberate through the
capital markets.
By understanding the reasons for the recent popularity of junk bonds, it should be possible to
put these concerns in perspective. This Letter
reports on an examination currently underway at
this Bank of the behavior of the junk bond market. We find that recent changes in the structure
of personal and corporate tax policy may be an
important stimulant to debt financing in general
and the junk bond market in particular.
Conventional explanations
Although numerous explanations have been
offered for the recent surge in junk bond issuance, most of these explanations do not survive
close inspection. One explanation, for example,
is that investment banks and brokerage firms
recently discovered an "untapped" investor
interest in high yield, high risk debt. It is true
that investment banks have been the vehicle
through which junk bond debt has been issued,
and that they have facilitated trading by maintaining markets in junk bonds. However, since it
is unlikely that long latent investor demand
would go unexploited, this explanation does not
account for why the market has grown so
rapidly in recent years.
A second conventional explanation is that
improvements in information technology now
make it economical to evaluate investments in
smaller and high-risk firms. Combined with the
growth of investment portfolios of sufficient
scale to permit diversified holdings of low-rated
debt, these improvements are seen as making
the issuance of junk bonds more feasible.
Although recent improvements in technology
may well be contributing to the development of
the junk bond market, they cannot offer a complete explanation since junk bonds also were
common in the first four decades of this century.
Indeed, noninvestment grade debt averaged
about 35 percent of all debt issued between
191 0 and 1947.
A third explanation for the recent jump in junk
bond issuance is that investor preferences have
changed in recent years and, in particular, that
investors now are less adverse to holding corporate securities. This argument is difficult to disprove since it is impossible to observe investor
preferences directly. But it leaves unexplained
why a similar surge in equity issuance has not
occurred. Certain propositions in finance theory
argue that a firm's debt and equity issues offer
the same risk-return opportunities on the margin
and equity certainty is a liquid security. In fact,
net new equity issuance in recent years has
actually turned sharply negative at the same
time that debt financing generally and junk bond
financing in particular have surged (Chart 1).
FRBSF
Debt vs. equity in the firm
There is an alternative explanation for the
resurgence of junk debt financing that also is
consistent with the dramatic decline of net new
equity issuance and increased debt issuance
generally. This explanation draws on the theory
of the capital structure of the firm ~ that is, the
amount of debt versus equity used by a firm to
finance its assets.
According to this theory, firms select a capital
structure that maximizes their value (the value of
their equity). Economists Modigliani and Miller
have shown that, in the absence of taxes, bankruptcy costs, and other sources of distortion, the
value of the firm in theory is independent of its
capital structure. In the real world, however, distortions exist and have been postulated to be the
source of a firm's preference for one capital
structure over another.
Taxes are particularly likely to influence capital
structure. Both corporate and individual income
is taxed in our economy. A firm is taxed on its
gross income minus (among other things) interest payments on its debt. Since interest expense
reduces corporate tax liability, it provides a "tax
shield" for the corporation's income, creating a
bias in favor of debt financing, everything else
being equal. These interest payments are,
however, income to individuals in the economy
and are taxed at the personal income tax rate.
If the corporation were to choose equity financing instead, it would forego the tax shield benefits of debt, but individual equity owners would
enjoy income in the form of capital gains. Capital gains enjoy preferential tax treatment since
personal tax obligations on such gains can be
delayed until shares in the firm are sold and,
untihecently, Were taxed at a lower rate than
other income. This preferential treatment creates
an offsetting bias in favor of equity finance.
Corporate vs personal income tax rates
Whether a firm chooses a debt- or equity-heavy
capital structure, therefore, may depend upon
the relationship between corporate and personal
tax structures. If the corporate tax rate were low
relative to the personal tax rate, the value to the
corporation of the "tax shield" offered by debt
would be low, whereas the benefits to individ-
uals of avoiding the personal tax liability associ"
ated with holding debt would be high. In such a
case, the market (that is, the combined effect of
firms and investors) would tend to prefer equity
finance. If the reverse (corporate tax rates were
high relative to personal tax rates) were true,
there would be a tendency toward debt finance.
This simple view of the effect of taxes on corporate financial structure implies that firms will be
either all equity or all debt financed depending
upon relative corporate and personal tax rates.
In reality, of course, we observe a mixture of
debt and equity in the economy and variations
in financial strategies across firms. Economist
Merton Miller has argued that the existence of
differentpersonal tax rates for different individuals creates "c1ienteles" for both debt and
equity that results in the observed mixture of
debt and equity in the economy.
Another explanation for the mixture of debt and
equity financing is that not all firms can take full
advantage of debt-related tax shields. For example, a firm for which tax shields are of no value,
such as one with low current income (as is the
case with start-up firms), would prefer equity
financing regardless of the tax structure. Firms
with high income and sufficient sources of tax
shields not related to debt (such as high
depreciation allowances, which are deductible
from the corporation's income for tax purposes)
also would prefer equity financing. Thus, the
ability to exploit debt-related tax shields and,
hence, the influence of tax policy on financial
structure, varies somewhat across firms. .
Tax policy and risky debt
The observation that high relative corporate tax
rates increase the preference for debt ("high
leverage") financing does not imply directly that
there would be an increase in high risk, "junk"
debt. For firms whose debt is on the borderline
of being noninvestment grade, however,
attempts to increase leverage would generate a
deterioration of their debt rating. Thus, if all
firms simultaneously desire higher leverage,
overall corporate debt must be more riskyon the
margin. Increases in junk debt issuance therefore
may naturally accompany attempts to increase
overall leverage.
Percent
Chart 1
The Tax Differential and the Issuance
of Corporate Debt and Equity
A more complex argument that may be used to
relate high-risk debt issuance to tax policy has
been made by economists Eli Talmor, Joseph
Zechner, and others. They point out that in the
u.s. tax code, all payments to debtholders in
excess of the market value of the debt at issuance are deductible and hence a potential
source of a tax shield. High yield (high risk) debt
by definition is debt whose promised payments
are large relative to the initial market value.
Hence, the greater the firm's leverage and the
riskier the debt, the greater is the value of the tax
shield of an additional dollar of debt. The riskier
the debt, of course, the greater is the likelihood
of default. It can be shown, however, that on
balance the value of debt as a tax shield still can
increase with the riskiness of the debt.
$ Billions
o
40
Tax Differential
.....
-5
~
Corporate Bond Issuance.,
-10
30
~;;;"'-~i""
20
•.J
~ .'
10
.::::.::::.::::.c.~>::.-,r.:.~'.:::.:.~.::::'~.!~ . :'~{
-15
Equity
I:s~~~ce'\
~
-20
i
i
V··fV:"
o
-10
-20
-25 L...L--'--.L..J=--'-'-J.--'--..L..J.--L...I-==-..L..J.--L...I-L-I -30
1965
1970
1975
1980
1985
*Net Dollar Flow
Source: FRBSF
Empirical evidence and conclusions
Chart 2A
The Tax Differential and Junk Bonds, 1900-47
$ Millions
Percent
10
01----'
j i
-10
•
-20
.....
-30
1250
..
1000
Tax Differential
\
750
•
~\.\
-40
500
".J
-50
-60
250
-70 L-----l_---L_---L_..l.-_l----l._---L_-'-_.l.....J
1900
1910
1920
1930
1940
o
1945
Source: Hickman, FRBSF
Chart 2B
The Tax Differential and Junk Bonds, 1975-86
Percent
$ Billions
or
1975
12.5
1980
1985 1986
Source: FRBSF, IDO Inc.
Thus, if tax policy makes debt-related tax shields
generally attractive, it also stimulates the issuance of risky debt. This proposition is demonstrated in the historical relationship between
financing activity and the difference between the
highest corporate and personal marginal tax
rates (the "tax differential"). As Charts 2A and B
illustrate, the volume of junk bond issuance
does indeed appear to have risen and fallen with
the tax differential, at least for the two periods
for which junk bond data are available. Chart 1
shows that the tax differential also appears to be
related to the very sharp decline in the net issuance of equity (and the increase in debt issuance) that has occurred in the last five years or
so.
Although conventional explanations also.may be
useful in explaining the debt finance "boom" of
recent years, the explanation offered here based
on the theory of the capital structure of the firm
is less ad hoc. In addition, it forecasts a particularly interesting implication of the tax reform
embodied in the 1986 Tax Act. By 1988, the top
marginal personal tax rate will beonly 28 percent versus 34 percent for corporations - a tax
differential of + 6 percent. This will be the first
positive tax differential since 1908 and the
largest in the 80-year historyof incometaxation
in the U ..5. Our analysis suggests that this differential could be a powerful stimulus to continued debt issuance generally and the junk
bond market in particular.
Randall Johnston Pozdena
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bankof San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U. S. Treasu ry and Agency Secu rities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Amount
Outstanding
Change
from
3/18/87
3/11187
204,474
183,877
54,032
67,879
37,228
5,441
13,486
7,112
207,020
51,574
34,835
19,439
136,007
792
1,111
439
29
75
19
335
17
- 1,378
1,247
-13,930
122
8
46,776
58
32,495
24,488
Period ended
3/9/87
-
Change from 3/19/86
Dollar
Percent?
-
-
-
-
-
22
1,048
-
471
1,338
246
1,512
3,584
213
2,715
905
5,545
3,842
2,332
4,110
2,408
957
2.0
5,761
2,848
- 15.0
- 10.4
Period ended
2/23/87
Reserve Position, All Reporting Banks
Excess Reserves (+ )jDeficiency (-)
Borrowings
Net free reserves (+ )jNet borrowed( -)
91
18
72
45
7
38
1 Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes
government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
5 Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change
2
3
u.s.
0.2
0.7
0.4
2.2
8.7
3.7
25.2
- 11.2
2.7
8.0
7.1
26.8
1.7
-
@FedFRASER