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FEDERAL RESERVE BANK OF RICHMOND MONTHLY Som e F actors A ffectin g L ong-term Yield Spreads in R ecen t Years E dge C orporations: A M icrocosm of International Banking T rends ■ ■ Volume 59 Number 9 SEPTEMBER 1973 Some Factors Affecting Long-term Yield Spreads in Recent Years Introduction T h e past d eca d e has been a p eriod between the corporate bond rate and the short-term of unprecedented movement in interest rates. Chart 1 Treasury bill rate m oved from a low of 24 basis shows the m ovem ent over this period in five co m points in January 1966 to a high o f 401 basis points in M arch 1971. m only cited interest rates series. T w o observations can be made from Chart 1 about the behavior of the interest rate series in the period shown. T he first is that the rates generally m ove in the same direction over time. A ll five of the series shown rose greatly T his characterization o f interest rate movement differs substantially from the standard m acroeco nom ic textbook treatment in which “ the” interest rate is determined by an appropriately specified in the late 1960’s, and all reached a peak in the first half of 1970. T he second observation is that the model. differentials am ong the interest rate series changed substantially over the 10-year period. T his observa rate spreads displayed little variation— then it would If the relationships am ong the interest rates were fairly constant over time— that is, if interest tion is true not only for long-term rates relative to the short-term rate, but it is also true of the long-term be o f little concern that there are many interest rates, since an appropriate explanation of the movement in any one of the interest rates w ould suffice as an rates relative to each other. T o take one example, at the beginning of the period in February 1964, the explanation for the m ovem ent in all other rates. corporate bond rate was only 25 basis points higher than the long-term United States governm ent bond rate. T he differential or spread between the tw o rates rose to 135 basis points in September 1966, fell to 88 basis points in February 1967, increased to 273 basis points in N ovem ber 1970, and fell to 153 basis points in February 1973. T he lack of stability that characterizes the spread between the corporate bond and U . S. governm ent bond interest rate series extends to the other interest rates as well, as shown in Table I, where all four of the other rates are com pared to the corporate bond rate. T he spreads between the corporate bond rate and the other rates varied 180 basis points or m ore in all four cases. In the most extreme case, the spread Table I Date 2.73 Nov. 1970 .25 types o f real investment. State and local bonds fi nance state and local construction, hom e m ortgages finance residential construction, corporate bonds p ri marily finance the construction o f plant and equip ment, and long-term U . S. bonds finance part o f the activity the form er finances becom es relatively m ore T o the extent F e b .1964 ing interest rates when making decisions on real J a n . 1966 to another can thereby affect the pattern of capital allocation in the econom y. Therefore, a change in a investment activity, a rise in one interest rate relative M inus Treasury 4.01 M arch 1971 .24 Corporate Bond Rate particular spread is a matter o f concern not only for M inus 1.15 June 1970 -1 .4 1 F e b .1964 Corporate Bond Rate the sectors supplying the securities but also for p oli cymakers whose decisions can influence interest rate relationships. M inu s State and Local Bond Rate Second, what causes this variation? T he answer to the first ques tion is related to the fact that securities are issued to finance a variety o f activities. In particular, different long-term securities are issued to finance different that the various econom ic sectors respond to chang Corporate Bond Rate M o rtga ge Rate First, of what concern is it that the spreads vary substantially over tim e? expensive, at least at first glance. M inu s U.S. Bill Rate questions. series for another of the securities, the cost o f the Low Corporate Bond Rate Bond Rate Security characteristics T h e size and v a ria b ility of spreads am ong interest rates raise tw o im portant of these securities rises relative to the interest rate 1964-73 Date over time, particularly in a period o f large interest rate movements, such as the late 1960’s. Federal deficit. W h en an interest rate series for one INTEREST RATE SPREADS High Unfortunately, as shown in Chart 1, the relationships am ong the various levels show substantial variation 3.08 2 A u g . 1970 1.28 Jan. 1966 T he second question— what causes m ovem ent in M ONTHLY REVIEW, SEPTEMBER 1973 the spreads— is extrem ely com p lex.1 T he five inter curities by these sectors is a w hole set of factors, est rate series shown in Chart 1 represent only a small fraction of the total number o f available interest sometimes called “ fundamental” influences on inter est rate movements. T h ey include the savings be havior of the various sectors and the real invest ment expenditures o f these sectors. A ls o included are certain policy variables o f the Federal Government that influence econom ic activity by directly affecting security supply or demand in a particular market. rate series. Salom on B rothers’ invaluable publication, A n Analytical R ecord of Yields and Yield Spreads, alone contains 111 different interest rate or yield series, which implies the existence of literally thou sands of spreads.2 These yield series can best be classified according to the characteristics o f the se curity or securities they represent. F or the purposes Attem pts to determine the effects o f these factors on interest rate spreads are greatly com plicated because of this article, these characteristics will be classified a given factor, such as household saving, has simul into three groups. T he first relevant characteristic of the security is taneous effects in many security markets. the length of its term to maturity. of a security relevant to a discussion of yield series is the special features it has with respect to the taxa bility, timing, and certainty o f the returns associated with holding it. T here are four such features that vary am ong securities.3 T he first is whether the The F ederal R e serve Bulletin, for example, provides yield series for U . S. governm ent securities maturing in three months, six months, one year, three to five years, and over ten years. T he spread between any pair of these series changes dramatically over time, as can be seen in Chart 1. Securities can also be characterized by the particu lar sectors of the econom y that issue and purchase them. U nderlying the supply of and demand for se T he third characteristic, or group o f characteristics, interest earned on the security is subject to Federal incom e tax. T he second is whether the security earns income in the form o f capital gains (o r capital losses), which are subject to low er tax rates than interest in come. T he third feature is whether the issuer o f the security has the option of repaying the principal 1 For an excellent discussion of many of these causes, see James C. Van Horne, Function and Analysis of Capital Market Rates (Engle wood Cliffs, New Jersey: Prentice-Hall, Inc., 1970). 2 The terms “ interest rate” and “ yield” will be used interchangeably in the remainder of the article. 3 The feature of convertibility of a bond into a common stock is not considered, since the article is concerned exclusively with bond yield spreads. Chart 1 Percent 10.0 INTEREST RATE LEVELS — M ortgage ■ Corporate Bond 9.0 - — Long-term U.S. Bond ..... 1-year Treasury Bill 8.0 — — State and Local Bond — 7.0 - 6.0 — TV1 5.0 \ : l t ' S A /V ' 4.0 3.0 2.0 1.0 Note: The corporate bond rate is for new callable corporate bonds rated A a by M o o d y 's Investor Service. The state and local bond rate is the Securities Industry A ssociation's series for new issue A a 20-year general obligations. The m ortgage rate is the FHA series for conventional new home loans. The two U. S. governm ent security rates are the 1-year Treasury bill rate and the seasoned long-term bond rate series. All are monthly averages of daily or weekly series, except for the m ortgage rate which is the rate as of the first day of the succeeding month. I _______ I _ ________ I ________ I ________ I _______ I _ ________ 1 ________ I _______ I _ --------1964 1965 1966 1967 Sources: Treasury Bulletin and Federal Reserve Bulletin. 1968 1969 1970 1971 1972 1973 ( “ calling” the security) at a time before it matures. A n d the fourth feature is the degree to which the income prom ised on a security is subject to uncer tainty or risk of default on the part of the borrow er. O n new issue securities, bonds typically sell at (o r near) par, which in this case is $1000. A djustm ents Each of the three security characteristics mentioned in yield are brought about by changes in C, the coupon. F or securities that are not new, but “ sea soned,” P will deviate from $1000 in order to keep is related to both the level and movement o f interest rate spreads over time. T he ideal procedure to use in the yield o f the security in line with current market interest rates. F or example, suppose a new 20-year attempting to explain the movement in spreads is to isolate one security characteristic at a time and study security is issued at a yield to maturity o f 5 percent, with P = $1000 and C = $50. F ive years later, the yield series for securities that are alike in all respects security, now seasoned, is resold when the yield to maturity on com parable new securities has risen to but that one characteristic. T he problem then is to determine the factors underlying the spreads associ 7 percent. Because the $50 annual coupon on the ated with that one characteristic (e.g. m aturity). Unfortunately, finding interest rate series that isolate seasoned security is low er than the $70 annual co u pon on the new security, investors will only purchase a given security characteristic is sometimes difficult, if not impossible. Nevertheless, this article w ill at the seasoned security at a reduced price. tempt to use that procedure in illustrating the effects (w here N now equals 15) w ould have to d rop to $817 in order fo r the yield to maturity to equal 7 that the four special features indicated above have had on observed yield spreads in the past ten years. T he article will not attempt to explain the elements of observed yield spreads related to differences in m a turity or to the behavior o f the various econom ic A ssum ing the absence o f all taxes, the price o f the security percent. T he buyer o f the security w ould realize a capital gain at the end o f 15 years of $183. T here are tw o features o f the yield form ula that, when com bined with the four special features, ac sectors, but it will be argued that any attempt to count for a large part of the variation in the yield explain those spreads requires an understanding of spreads in Chart 1 and Table I. First, it should be noted that the form ula com putes the b efore-ta x yield the impact on yield spreads of the special features. Assumptions underlying the computation of yield series O b s e rv e d spread s b e tw e e n in terest rate series, such as those in Chart 1, contain an important element that results from inherent shortcom ings in the form ula em ployed in calculating yields. Spreads between yield series for securities that differ only with respect to one of the fou r special features dis cussed above are related in that they all result from these shortcom ings. T h e yield of a security is the discount rate, r, which equates the price, P, o f a security to the present value of the future cash flow s associated with holding i t : (') p = ( T^ + < 1 T ^ + T where Q period.4 + (T+Tj" ' to maturity, when clearly the after-tax yield is the relevant consideration for the buyer o f a security. Therefore, the yield form ula (w hich is used to co m pute the interest rate series in Chart 1) cannot differentiate between securities that provide interest income that is or is not subject to personal and c o r porate incom e tax. N or does it differentiate between securities that yield or do not yield a return in the form o f capital gains that are taxed at a low er rate than interest income. In the second place, implicit in the form ula is the assumption that the timing and amounts of the returns associated with holding a security are known is the prom ised return in the ith time with certainty. Therefore, the form ula cannot be used to calculate, with precision, the yield on securi In com puting the yield, the assumption is ties that are callable, either immediately or after a usually made that the security is held to maturity, so deferred period. M oreover, it cannot take into F or sim account the varying degrees of certainty felt by in plicity, the remainder o f the article w ill assume that vestors that the issuer of the security will not default. that r becom es the “ yield to maturity.” we are dealing with a bond that pays a constant re T he rest o f this article will look at and attempt to turn, C, each year until it matures in period N , at explain spreads am ong long-term interest rates aris which time it pays the holder o f the security its face ing prim arily out o f the failure of the yield to m a value of $1000. T he yield to maturity is then com turity form ula to take account o f the effects on puted by finding the value o f r that satisfies the com puted interest rate series of incom e tax rates, eq u a tion : capital gains tax rates, call provisions, and default risk. Income tax rates and yield spreads T h e a fter-ta x yield to maturity of a security for a particular in 4 An explanation of this formula can be found in any introductory finance book. 4 vestor is the discount rate, r*, which equates the MONTHLY REVIEW, SEPTEMBER 1973 price of the security to the present value of the future after-tax prom ised retu rn s: (2 ) P = * y “ C ( l - t ) — --------- - + (l + r*)“ ^ ( 1 0 0 0 - P) ( l - e g ) ----------------- —--------- — (1 — r * ) N f- p H ---------------------, (1 + r * ) N where t is the marginal income tax bracket of the investor and eg is the tax rate on long-term capital gains. T he interest income, C, is taxed at the rele vant personal or corporate income tax rate, while the capital gains ($1000 — P ) are taxed at the capital from the preceding discussion that all the change in the spread cannot be attributed to the tax factor, since the effects of the tax factor have not been isolated from those of the other factors discussed. F or the period 1966-1968, it appears that a m ajor part of the movement in the spread can be explained by the differential tax status. In that period, the spread rose and fell with interest rate levels, keeping the relationship between the after-tax yields on the two securities relatively constant. In 1969, however, gains tax rate. O ver much of the past 10 years, eg was equal to one-half of t, up to a maxim um tax of interest rates rose sharply, while the spread opened only moderately. 25 percent of total capital gains.5 By using Formulas ( 1 ) and ( 2 ) and by specifying It should be noted that since the yield series in Chart 2 are for new securities selling at par, the an income tax rate, a capital gains tax rate, a matur equal-after-tax relationship between the state and ity date, and a coupon value, it is possible to deter local rate ( r si) and the corporate bond rate ( r cor) series can be expressed simply as mine, for any security, a before-tax yield that is con sistent with any after-tax yield.6 The effects of vary (3 ) ing income tax rates, capital gains tax rates, maturi ties, and coupons on the relationship between beforeand after-tax yields to maturity, and consequently on yield spreads, can then be isolated. rsi = (1 t ) r cor • A lthough t varies am ong individuals, it has been fairly constant for corporations, about 50 percent, over the period shown in Chart 2. Form ula ( 3 ) can A n example of this procedure is reported in Table II. T he relevant marginal income tax rate is shown be used to determine a marginal tax rate at which investors w ould be indifferent in choosing between for values of 30 percent and 40 percent, and the new state and local bonds and new corporate bonds capital gains tax rate is assumed to be one-half the o f the same quality. income tax rate. T he hypothetical securities are new issues sold at par. It is assumed that one security yields interest income that is tax-free, while the other yields interest income taxable at the indicated m ar ginal tax rates. It is also assumed that investors demand equal after-tax rates. T w o points, which are evident from examination of the table, are rele vant to the discussion o f the relationship between That tax rate w ould be (3' ) v t* = rsl r— 1 - 1 cor • A n investor in a marginal tax bracket greater than t* would prefer state and local bonds to corporates. The t* series is shown in Chart 3. T he series averages about 32 percent over the period and never reaches 40 percent. A s w ould be expected, these values o f t* the yield to maturity form ula and yield spreads. lead to a situation in which the market for state and First, in a period of rising interest rates, spreads between yield series for securities that yield taxable interest versus those that yield tax-free interest should rise. A n d second, increases in income tax local securities is com pletely dominated by financial institutions subject to corporate income tax rates— Table II rates should also increase those spreads. EFFECT OF INCOME TAX ON BEFORE-TAX YIELD SPREADS A s is well known, interest income on state and local securities is generally tax-free. Chart 2 com pares the movement of the corporate bond rate with Spread Between Before-tax Yield of a N ew Issue Security the movement o f the spread between the corporate Providing Taxable Interest Income (rj) and Before-tax Yield bond rate and the state and local bond rate. rates are for new issues.7 Both of a New Issue Security Providing Non-taxable Interest Income (r2) Assum ing Equal After-tax Yields There is clear evidence that the spread rises as interest rates rise, as was predicted in Table II, although it should be clear t=4 0 % t= 3 0 % Spread 6 This fact was pointed out in an article by J. W . Colin and Richard S. Bayer, “ Calculation of Tax Effective Yields for Discount Instru ments,” Journal of Financial and Quantitative Analysis, 5 (June 1970), 265-73. 7 Unless otherwise stated, the interest rate series referred to are those in Chart 1. rl 3.00 3 The relationship of t to eg became somewhat more complex in 1970 after maximum capital gains tax rates were increased. r2 ri Spread r2 5.00 2.00 3.00 4.29 1.29 3.50 5.83 2.33 3.50 5.00 1.50 4.00 6.67 2.67 4.00 5.71 1.71 4.50 7.50 3.00 4.50 6.43 1.93 2.14 5.00 8.33 3.33 5.00 7.14 5.50 9.17 3.67 5.50 7.86 2.36 6.00 10.00 4.00 6.00 8.57 2.57 FEDERAL RESERVE BA N K OF RIC H M O N D 5 com m ercial banks and casualty insurance companies— and by high incom e individuals.8 Capital gains tax rates and yield spreads C hart 4 com pares the movement of the corporate bond yield series with the spread between the corporate bond yield series and the long-term U . S. governm ent bond yield series. T he yield series and the spread m ove very closely together indicating that, during the years shown, the spread increased when interest rates rose 8 Of the total $166.47 billion outstanding in state and local securities at the end of 1971, the household sector held 31.41 percent, casualty and fire insurance companies held 11.59 percent, and commercial banks held 49.78 percent. A factor contributing to the failure of the spread between the corporate and state and local bond rates in Chart 2 to rise in 1969 was undoubtedly the behavior of the com mercial bank sector, which virtually withdrew from the state and local market, thereby creating upward pressure on the state and local bond rate relative to other long-term rates. and decreased when interest rates fell. T his section and the follow in g will deal with tw o o f the m ajor factors causing this relationship. T he corporate bond yield series in Chart 1 is for new issue bonds selling at or near par, while the long-term U . S. governm ent bond yield series is for seasoned bonds. T here is no yield series fo r new issue long-term U . S. bonds since none were issued over most of the period under consideration because the m axim um legal coupon was 4.25 percent until 1971. Thus, the long-term U . S. bond yield series over m ost of the period is fo r a group o f securities having coupons of 4.25 percent or less. T he average coupon rate on the bonds making up the yield series in June 1970, when interest rates were at their peak, was only 3.64 percent. Chart 3 M ARGINAL TAX RATE AT WHICH A N INVESTOR WOULD BE INDIFFERENT BETWEEN CORPORATE AND STATE-LOCAL BONDS Percent 4 0 f— Chart 4 CORPORATE BOND YIELD AN D SPREAD BETWEEN CORPORATE A N D LONG-TERM U. S. YIELDS Percent Percent Note: Yield series are those described in Chart 1. Table II I shows the spreads between the before tax yields on a new security selling at par and a most one-half the movement of the spread in Chart 4.9 Table I V recomputes the spreads with a coupon o f seasoned security with a $40 coupon, for equal-after tax yields. T he income tax rate of the investor is $30, and the other assumptions unchanged. assumed to be 40 percent, the capital gains tax rate, 20 percent, and N , 20 years. A s interest rates rise, the price of the seasoned bond falls, increasing the security, the greater the discount and, consequently, the greater the amount of the return of the security in the form o f capital gains. T his results in an in amount of income that is received in the form o f crease in the spread for any specific after-tax yield. capital gains. Chart 5 com pares tw o yield series from Salom on Brothers that are for tw o sets o f securities which are Since capital gains are subject to a substantially low er tax rate than interest income, a low er before-tax yield on the seasoned bond is re quired to provide an after-tax return equal to that o f the new bond. U nder the assumptions made in Table III, this “ capital gains” effect on the seasoned long-term U . S. bond yield series would explain alTable III BEFORE-TAX YIELD SPREAD N e w vs. $40 Coupon Seasoned Security ostensibly alike in all respects except that one is new and the other is seasoned with a 4 ^ - 4 ^ percent coupon. T he yield series are both for deferred call able A a public utility bonds.10 T he spread between the tw o yield series is similar to that indicated under the assumptions made in Table II I and corroborates the capital gains tax effect on yield series between yields for new and seasoned discount bonds. Chart 5 indicates an apparent change in the relationship be tween the spread and interest rate levels beginning in Spread Between Before-tax Yield of N e w Security (r^) and Before-tax Yield of $40 Coupon Seasoned Security (r2) 1970. One explanation for this change is that the T a x R eform A ct of 1969 increased maxim um capital Assum ing Equal After-tax Yields (r*) N = 20 t = 4 0 % A s the table indicates, the low er the coupon on the seasoned gains tax rates from 25 percent to 32.5 percent for eg = 2 0 % individuals and to 30 percent for corporations. r* r2 P -2 rl Pi Spread 2.40 4.00 $1,000.00 4.00 $1,000 .00 3.00 4.79 899.62 5.00 1,000 .21 4.00 6.10 760.72 6.67 1,000 .57 5.00 7.41 649.57 8.33 1,000 .92 6.00 8.73 559.62 10.00 1,000 1.27 A s suming an equal-after-tax yield of 4 percent and a 9 Of course, over the period, the average term to maturity of the $40 coupon securities would decline; however, at large values of N, this would have a very small effect on the spreads in Table III. 10 The word “ ostensibly” is used because a high coupon deferred callable bond is more likely to be called than a low coupon deferred callable bond. FEDERAL RESERVE BA N K OF R ICH M O N D 7 Table IV A a deferred callable, new, utility bond yield series with the spread between it and the yield series for a BEFORE-TAX YIELD SPREAD similar bond that differs only in that it is seasoned with an 8 - 8 ^ percent coupon. T he chart clearly indicates that when market rates fell below the N e w vs. $30 Coupon Seasoned Security Spread Between Before-tax Yield of a N ew Security (r^) and Before-tax Yield of a $30 Coupon Seasoned Security (r.,) coupon (8 p ercen t), the observed yield on the sea Assum ing Equal After-tax Yields (r*) soned bond became larger than the new issue bond N = 20 t = 4 0 % eg = 2 0 % yield. r* Spread Table V shows the before-tax yields on a 1.80 3.00 3.00 $1,000 .00 hypothetical premium seasoned bond with an $80 coupon necessary to give after-tax yields equal to 2.50 3.91 875.71 4.17 1,000 .26 those on new issues in a period when interest rates 3.00 4.55 799.24 5.00 1,000 .45 4.00 5.83 670.98 6.67 1,000 .84 are below 8 percent. T he results are similar to the actual spread in Chart 6. 5.00 7.10 568.70 8.33 1,000 1.23 6.00 8.38 486.23 10.00 1,000 1.62 r2 P2 $1,000.00 rl Pl Recently, new long-term U . S. bonds at current coupons have been issued. A t the present time, three marginal income tax bracket of 50 percent, the effect of the ten bonds in the sample used to com pute the of an increase in the capital gains tax from 25 percent long-term U . S. bond series are high coupon (o v e r 6 to 30 percent w ould be to decrease the spread be percent) bonds. tween the before-tax yields of a new security selling at par and a seasoned one bearing a $40 coupon from bonds in the sample should affect the relationship T he presence of the high coupon between the U . S. governm ent bond yield series and the other series. Chart 4 provides some support for 114 to 104 basis points. Thus, the increase in capital gains tax rates would explain some, but apparently not all, of the change in the relationship in 1970 be this expectation in that it appears that in 1973 the tween the tw o curves shown in Chart 5. smaller than it has been at similar interest rate levels in the past. spread between the corporate and U . S. bond rates is W h en interest rates have fallen from past levels, seasoned securities with coupons higher than pre vailing market interest rates will sell at a premium Call provisions and yield spreads A th ird elem en t ( P > $1000) and, consequently, will yield a capital entering into observed yield spreads results from the loss at maturity. inability of the yield to maturity form ula to account U nder these circumstances, in vestors would be expected to demand a higher before for differences in call provisions. tax yield to maturity on the seasoned bond. Chart 6 demonstrates this effect by com paring the yield of the give the issuer of the security the option o f prepaying the face value before the stated time of maturity. Chart 5 NEW BOND YIELD A N D SPREAD BETWEEN NEW AND 4Vs-4% COUPON, SEASONED YIELDS Percent Percent Note: Yield series are for A a deferred callable utility bonds. Source: Salom on Brothers, A n Analytical Record of Yields and Yield Spreads. Call provisions Table V BEFORE-TAX YIELD SPREAD N e w vs. $80 Coupon Seasoned Security Spread Between Before-tax Yield of a N ew Security (rj) and Before-tax Yield of A n $80 Coupon Seasoned Security (r.,) A ssum ing Equal After-tax Yields (r*) and N o Tax Break O n Capital Losses11 r* r.) N = 20 t= 40% rl P2 Spread p, .00 w illing to pay for the security will clearly be influ enced by the amount o f call protection he gets— in terms o f the period of deferment and the call price— and by his expectations of the degree and timing of future interest rate movements. A reasonable be havioral assumption is that a price will be determined at which the marginal investor will be indifferent between purchasing the security with a call provision versus one that is noncallable. That is, a price (o r cou p on ) will be determined such that r ', the expected holding period yield (w hich depends on m, C P , and 4.80 8.00 $1,000.00 8.00 $1,000 4.50 7.61 1,039.02 1,000 4.00 6.98 1,108.72 7.50 6.67 1,000 -.3 1 3.50 6.35 1,184.76 5.83 1,000 -.5 2 bond with a maturity of N years com puted by fo r 3.00 5.72 1,267.79 5.00 1,000 -.7 2 mula ( I ) . 33 -.1 1 V irtually all corporate bonds and m ortgages have some kind of call provision, while state and local bonds do not. Som e U . S. governm ent bonds are callable, but the long-term U . S. bond yield series shown in Chart 1 excludes bonds callable in less than 10 years. Call provisions for corporate bonds for which yield series are available specify that the bond is callable either immediately or after a deferred period of five years. Typically, if the bond is called, a penalty is paid by the issuer, which varies directly with the remaining years to maturity. A com m on penalty for a corporate bond called after five years w ould be one year’s coupon. i ) , will equal r, the yield to maturity o f a noncallable T he general implications for yield spreads of the difference between form ulas ( 1 ) and ( 4 ) are fairly straightforward. First, if interest rates are not e x pected to drop enough to justify the issuer of the security to prepay the face value of the security (given the presence of the call penalty and refinan cing co sts), then expectations will be that the security will not be called. Investors will not be willing to pay a premium (accept a low er yield ) for call deferment provisions, and the yield to maturity form ula ( 1 ) will give com parable yields for securities with differ ent call provisions. If interest rates are expected to fall enough that the security will be called and if the subsequent expected holding period yield, as indi Y ields on bonds with call features are calculated, like yields on bonds without call features, by the yield to maturity form ula ( 1 ) . T he resulting effects on cated by form ula ( 4 ) , becom es smaller than r, the yield to maturity of a noncallable security, then the observed yield spreads can be seen by considering the case of an investor with m oney to invest for N years w ho buys a N -year bond subject to call any time after it is issued. If the bond is called, the in vestor reinvests the call price (the face value plus the call pen alty), C P , immediately at the current market rate of interest, i, until the end o f the original N years. H is expected (h olding p eriod ) yield over the N years is the discount rate, r ' , which equates the price of the security with the discounted value of 1 This assumption implies, contrary to currently accepted theory, 3 that investors do not demand a higher expected (than certain) return in exchange for the uncertainty associated with buying the security with the call provision. The same simplifying assumption is made in the next section with respect to another type of uncer tainty. The assumption does not affect any of the general conclu sions. Chart 6 NEW BOND YIELD AND SPREAD BETWEEN NEW AND 8-8% COUPON, SEASONED YIELDS Percent Percent the ex p ected future incom e flow s :12 (4 ) r= T — - — “ x (i + rT V + (l)C P - + J r + 1 (1 + r') '1 1 CP— .O + . fT T he call date, m, and the market interest rate at the date of call, i, are clearly matters of uncertainty, unless there is a deferred call provision, in which case it is at least known that the bond cannot be prepaid before the end of the period o f deferment. T he attitude of the investor towards the price he is 11 In fact, part of the capital loss is deductible against current in come. Introduction of this factor would make the spreads in Table V smaller. 12 In order to keep the discussion manageable, taxes will be ignored in both this section and the next. Doing so does not affect any of the basic conclusions. Note: Yield series are for A a deferred callable utility bonds. Source: Salom on Brothers, A n Analytical Record of Yields and Yield Spreads. FEDERAL RESERVE BA N K OF RIC H M O N D 9 coupons on the callable security will have to rise (o r in the case of a seasoned security, the price will have to fa ll) in order to equate r and r ' . U nder these circumstances spreads will be created between calcu lated yield series for securities with different periods of call deferm ent.14 Salom on Brothers has calculated yield to w illing to accept a low er yield in return for five years of call deferment. T he chart shows positive values both in the early and late 1960’s. T h e chart also demonstrates that, over the period shown, expecta tions of future interest rate changes m oved inversely with respect to interest rate levels. m a A n alternative way of illustrating the effect of the turity series up to 1969 for securities that are identi call feature on yields is to com pute the yield to call cal in all respects except that one set is immediately (b y assuming the call price is paid at the end o f the callable, while the other has a deferred call period of period o f deferm ent) and com pare it to the yield to maturity for a given security. A s indicated by fo r five years.15 Therefore, the spread between these tw o series, shown in Chart 7, isolates the effect of five years call deferment. Given the above discussion, investor expectation has to be that interest rates will fall in the five years follow in g any period when the mula ( 4 ) , a low value of expected future interest rates com pared to current interest rates will raise coupons (o r low er prices) on securities with a call provision, so that the higher yield on the security for the period until it is called will compensate for immediately callable rate rises above the deferred the low er expected yield thereafter. Chart 8 shows callable rate. the spread between the yield to call and yield to m a Otherwise, investors w ould not be turity of 8 ^ 2 -9 ^ percent coupon A a utility bonds 14 By imposing the condition that r in formula (1) equals r ' in formula ( 4 ) , and by specifying values for CP, i, m, and N, specific spreads between calculated yields to maturity on bonds with differ ent call provisions are implied. For instance, suppose a noncallable 20-year bond, selling at par, has a $60 coupon and, consequently, a yield to maturity of 6 percent. Let CP = $1000 C and assume that interest rates are expected to fall to a “ normal” level, i, in three years and remain at that level. If i equals 5.50 percent, then no premium will be demanded on bonds with less than 20 years call protection. However, if i is equal to 5.25 percent, the coupon on an immediately callable security will be $65.70 and the coupon on a security with five years of call protection will be $62.61. The cal culated yields to maturity will be 6.57 percent and 6.26 percent, respectively, implying that investors demand a premium of 57 basis points to buy the immediately callable security and 26 basis points to buy the deferred callable security. The value of five years call protection would be 31 basis points. 15 The series for immediately callable issues was discontinued in 1969 because of the absence of any new callable issues. with a five-year deferment period issued in 1970, at a time when long-term record high. interest rates were at a T he chart supports the evidence from Chart 7 that when interest rates are high, purchasers o f securities with call provisions demand to be co m pensated for the expected low er yields follow in g the end of the deferment period. T he differential in the tw o yields was wiped out before the end of the d efer ment period, however, when long-term rates fell at the end of 1970 and the beginning o f 1971.16 Chart 7 shows the value o f five years call defer ment at different points in time arrived at by isolat ing that particular special feature. A n important question posed by Chart 7 is what is the value and what is the effect on yield spreads o f longer periods of call deferment ? In particular, what is the value o f call deferment until maturity (fo r 20 or 30 years) Chart 8 YIELD TO MATURITY ON 8V2-9Vb COUPON BOND AN D SPREAD BETWEEN YIELD TO CALL AND YIELD TO MATURITY Percent Percent that characterizes state and local and most U . S. governm ent bonds ? T he specific answer to that ques tion is unknown, since there are no yield series that isolate longer periods of call deferment.17 One can only speculate that in periods o f high interest rates, such as 1969-1970, calculated yield series for securi ties with call provisions w ou ld rise significantly relative to long-term yield series for securities with Note: Yield series are for A a seasoned utility bonds. complete call protection. It seems likely, for example, Source: Salom on Brothers, An Analytical Record of Yields and Yield Spreads. that part of the unexplained increase in the spread between the corporate bond and U . S. governm ent bond rates in the late 1960’s resulted because the latter series excluded bonds callable in less than 10 years. In any case, the point is that call provisions will not only affect the spreads between various co r porate bond rates, but they will also affect spreads between yield series for corporate bonds and other types of long-term securities with longer periods of substantial effect on the calculated yield series. Chart 9 shows the usual F H A -in su red yield series com pared to a recomputed one18 in which the call date assump tion is changed from 15 to 10 years. T he latter rate shows almost as much movement in the last 10 years call deferment. Y ield series for m ortgages, unlike those fo r the other long-term securities, are com puted by assuming that the mortgage is called ( “ prepaid” ) at a date before maturity. m ortgage. W h en the assumed prepayment date is changed for such discount m ortgages, it can have a A lthough there are often “ prepay as the corporate bond yield series in Chart 1. spread between the conventional m ortgage The rate, shown in Chart 1, and the corporate bond rate, h ow ever, fell considerably during the same p eriod.19 ment penalties,” they do not enter into the com puta Default risk and yield spreads tion of com m only used yield series. F or the yield series on conventional m ortgages shown in Chart 1, last element in yield spreads to be considered results T h e fou rth and the calculated yield series. F or yield series on F H A - from the fact that the yield to maturity form ula im plicitly assumes that the prom ised returns associated with holding a particular security are know n with insured m ortgages, however, the prepayment assump tion can substantially affect the yield series, because F H A -in su red m ortgages sell at a discount when certainty and that there is no risk o f delay or failure in making those returns. In fact, there is default risk associated with holding m ost securities, and the market yields are greater than the m axim um perm is sible “ interest rate” on the mortgages. In order to raise the effective yield of the m ortgage, the p u r amount o f this risk as perceived by investors varies from security to security. the prepayment date assumption has little effect on chaser adjusts the actual amount o f the loan rather than the m onthly payments. In the context o f fo r Consider, as an example, the situation of an in vestor faced with the option of buying one of tw o securities. T he first one is, say, a U nited States mula ( 1 ) , when C is at the legal m axim um , the governm ent bond, which is assumed to be completely yield, r, is adjusted by changes in P , the price of the free of default risk. T he yield to maturity, ri, will be 1 After setting values for CP, i, m, and N, and imposing the condi 8 tion that r in formula (1) equals r ' in formula (4 ), the yield to maturity and yield to call on a deferred callable security can be calculated and compared. Because of the call penalty, a yield to call greater than yield to maturity does not necessarily imply an expectation of falling interest rates. However, given fixed interest rate expectations, a fall in interest rates from a level at which a deferred callable security has a higher yield to maturity than a noncallable security will decrease the spread between the yield to call and yield to maturity of the deferred callable security. 18 The series was recomputed through 1967 in an extremely interest ing book by Jack M. Guttentag and Morris Beck, New Series on Home Mortgage Yields Since 1951 (New York: National Bureau of Economic Research, 1970), p. 184. The series was recomputed from 1968 to the present by making the assumption that the relationship between the changes in the two series was the same as in the earlier period. If anything, the difference between the two series is under estimated in the latter period, since FHA-insured mortgages had even greater discounts in that period. 17 One estimate is that the value of a 30-year call deferment in a period of high interest rates is 70 basis points. See Gordon Pye, “ The Value of Call Deferment on a Bond: Some Empirical Results,” The Journal of Finance, 22 (December 1967), 623-36. 1 Guttentag and Beck, op. cit., pp. 63-70, provide a reasonable 9 explanation, based on the behavior of the different sectoral partici pants in the two markets, for the greater movement of the F H A insured mortgage rate series than the conventional mortgage rate series in the period under consideration. FEDERAL RESERVE BA N K OF RIC H M O N D 11 will default, either by nonpayment or delayed pay securities is apparently determined largely by quality ratings made by investment agencies such as M o o d y ’s Investors Service. T he market risk premium o f a security wih a given rating is the spread between the yield series for that rating and that of a U . S. govern ment of the coupons or face value of the bond. ment security of comparable maturity. accurately determined by form ula ( 1 ) and will be known with certainty. The second security is a co r porate bond for which the investor definitely feels there is some possibility that the issuing corporation He will foresee a number of possible streams o f returns associated with holding the bond, only one of which corporate bonds rated by M o o d y ’ s. T he highest, Aaa, corresponds to the full promised amounts at the is for “ bonds with the smallest degree o f investment prom ised time periods. r is k ; interest payments are protected by a large or by an exceptionally stable margin and principal is se B y em ploying form ula ( 1 ) each possible stream of returns implies a different yield to maturity for the bond. T he investor’s e x pected yield to maturity on the second bond, r2e, can be thought of as the average of all the possible yields Chart 10 shows yield series for four categories of cure.” T he lowest rating shown, Baa, is for bonds whose “ interest payments and principal appear ade to maturity com puted in this fashion. Clearly, if ri, the prom ised yield to maturity on the risk-free bond, quate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time.” Since none o f the is equal to r2, the prom ised yield to maturity on the bond subject to default risk, then r x will be greater four yield series ever intersects, the opinions o f in than r 2e, the expected yield to maturity on the risky bond. T he investor, that is to say the market, will prefer the default-free bond to the one perceived to have default risk. T his preference will drive up the price of the default-free security relative to the price o f the risky security to the point where ri = r2e. H ence r2, the calculated yield series on the risky security, will be greater than rt. T he difference be tween r2 and ri is generally called the “ market risk vestors, in general, correspond with those of M o o d y ’s. A com m only asked question is what determines the quality rating of a particular security?20 Variables that have been cited in response to that question fall into tw o predictable classes. T he first set o f vari ables is related to the balance sheet o f the issuer of the security, and the second set to the size and sta bility of the issuer’s net incom e flow s. F o r example, balance sheet variables that have been determined to In the w orld de be related to the quality ratings o f corporate bonds are ( 1 ) the ratio o f long-term debt to total capitali scribed above, it would equal r2 — r2e, the “ expected zation, a measure of leverage, and ( 2 ) the market prem ium ” for the risky security. default loss” (difference between the prom ised and expected yields to m aturity) on the risky security. In the real w orld the perceived quality, or relative lack o f default risk, on state and local and corporate Digitized for12 FRASER 20 Recent articles that have dealt with this question are Thomas F. Pogue and Robert M. Soldofsky, “ W hat’s in a (Corporate) Bond Rating?” Journal of Financial and Quantitative Analysis, 4 (June 1969), 201-28, and Williard T. Carleton and Eugene M. Lerner, “ Statistical Credit Scoring on Municipal Bonds,” Journal of Money, Credit and Banking, 1 (November 1969), 750-62. M ONTHLY REVIEW, SEPTEMBER 1973 Chart 10 YIELD SERIES FOR CORPORATE BONDS RATED Aaa, Aa, A, AN D Baa BY MOODY'S Percent value of all publicly traded bonds of the com pany, a larly in the fourth quarter, which was the worst. measure of marketability. Incom e variables that have been related to corporate bond ratings are the earn ings variability of the com pany and the ratio o f after D uring the rest of the period, however, the spread did not m ove closely with changes in real G N P . T he same general observation may be made for state and tax net income plus interest charges to interest local rates over the period. Table I shows that the spread between the c o r charges, a measure of earnings coverage. A second question is whether the yield spreads embodied in market risk premium s respond inversely porate bond rate series and the long-term U . S. T he governm ent bond rate series shown in Chart 1 reached its peak in the fourth quarter of 1970. In spread between M o o d y ’s Baa and A aa corporate bond view of the previous discussion and Chart 11, it yield series is shown in Chart 11. Clearly, the spread rose substantially in the recession of 1970, particu appears likely that the m ovem ent in the spread be to cyclical movement in econom ic activity. tween the tw o interest rate series was affected not Chart 11 SPREAD BETWEEN MOODY'S Baa AN D Aaa CORPORATE BOND YIELD SERIES Percent FEDERAL RESERVE BA N K OF RIC H M O N D 13 only by the capital gains tax effect and call risk but also by a cyclical movement in default risk premiums. The relationship of the special features to the other security characteristics T h e d iscu ssio n at the beginning o f this article centered around the notion that yield spreads could be neatly divided into three classes related to characteristics o f marketable securities. T he three classes of spreads w e r e : ( 1 ) those associated with differences in maturity, ( 2 ) those associated with differences in econom ic sectors that issue and purchase various securities, and ( 3 ) those associated with differences in the four special features discussed in this article. In reality, however, it is extremely difficult to isolate the part of an observed yield spread related to each of these characteristics, as has been shown with respect to the special features. It is useful to consider briefly the difficulties the presence of the special features can pose in attempting to isolate and explain the amount of an observed spread between security yields that is related to differences in m a turity or to the behavior of the particular econom ic sectors that participate in the market for the securi ties. T w o exam ples should suffice. First, in discussing the movement in yield spreads over time related to different maturities (the term stru ctu re), U . S. securities are generally used. T he U . S. security yield curve fo r maturities greater than five years. This bias increases as the difference between the coupon and current market rates increase and as taxes increase.21 A ttem pts to isolate movements in yield spreads associated with the activity o f different econom ic sectors are also difficult. F o r example, consider the case of an increase in U . S. governm ent debt financed by long-term bonds. A n interesting question is how will this action affect the long-term U . S. bond inter est rate relative to other rates, such as the corporate bond rate. T o attempt to answer this question, it is clearly desirable to have a corporate bond rate and a long-term U . S. bond rate for securities that are identical in all respects, in order to isolate the m ove ment (if an y) in the spread associated with the governm ent debt financing operation. T he relation ship between the tw o interest rates in Chart 1, h o w ever, is also affected by capital gains tax treatment, by call risk, and by default risk.22 Furtherm ore, in the period under consideration, there is no pair o f long-term corporate and U . S. bond rates series that are not influenced by these factors. Conclusion B y fo c u s in g on the m o v e m e n t o f interest rate series over the past 10 years, this article has attempted to demonstrate how the inability o f the yield to maturity form ula to deal with taxes and implicit assumption is that these securities are alike uncertainty in calculating yield series contributes to in all respects except maturity. Table V I shows, however, that this was not the case in the period the creation under consideration, since the long-term U . S. se curity yield series was for discount bonds. A s the table indicates, a situation was created in which the securities also differed with respect to their tax treatment, im plying upward bias, albeit small, in the and movement of observed spreads am ong various long-term interest rates. In particular, the article has shown that both incom e tax and capital gains tax rates have effects on observed yield spreads that vary with interest rate movements. T he article also has illustrated the effect o f call provisions on observed yield spreads and has shown how default risk influences yield spreads. T he article has made no attempt to explain ele ments o f observed yield spreads associated with Table V I EFFECT OF TAXES ON TERM STRUCTURE OF BEFORE-TAX YIELDS differences in maturity or associated with the be Effect of Taxes On The Term Structure of Before-tax Seasoned has pointed out, however, that these questions, par Security Yields (r) A ssum ing Equal After-tax Yields (r*) ticularly the latter, are greatly com plicated by the havior of different econom ic sectors. C = 40 eg = Vit effect on the level and m ovem ent of yield spreads o f the four special features discussed. t= 50% t= 40% P r 8.07 602.28 9.01 542.54 7.99 658.22 8.86 604.39 735.35 8.76 690.96 843.71 8.71 815.19 8.73 956.50 T im othy Q. C ook P r r* N 5.5 20 5.5 15 5.5 10 7.93 5.5 5 7.90 5.5 1 7.91 963.77 14 T he article 2 The effect of taxes on the term structure of U. S. security yields 1 was discussed by Alexander A . Robichek and W . David Niebuhr in “ Tax-Induced Bias in Reported Treasury Yields,” Journal of Fi nance, 25 (December 1970), 1081-90. 22 Of course, an even greater problem is that there are other eco nomic sectors that are simultaneously acting in the securities mar kets, thereby influencing the relative yields. M ONTHLY REVIEW, SEPTEMBER 1973 EDGE CORPORATIONS: A Microcosm of International Banking Trends T he grow in g and changing role of U . S. banks in international finance is closely reflected in the recent proliferation of E dge A ct C orporations and their activities abroad. A n E dge A ct C orporation is a banking subsidiary organized under Section 2 5 (a ) of the Federal R eserve A ct to conduct international E dge Corporation. A second and m ore serious e ro sion occurred with the 1970 amendments to the Bank H old in g Company A ct of 1956, as implemented by Regulation Y o f the B oard o f Governors. One amendment permitted bank holding com panies to invest in any com pany in which an E dge Corporation banking and financing operations. T he styling is derived from the name of Senator W alter E dge of may invest other than one that accepts deposits in the N ew Jersey, the sponsor of the 1919 legislation au panies were permitted investments previously denied United States. In other w ords, bank holding com thorizing the Federal chartering of these institutions, to com m ercial banks but permitted to their E dge sub largely by way of im proving the com petitive position of U . S. banking institutions in international markets. sidiaries. W ith the adoption o f these tw o amend ments, either banks or bank holding com panies could Earlier legislation in 1916 had permitted the state acquire, foreign equity interests form erly limited to chartering of such institutions, which have since com e E dge Corporations. to be known as A greem ent C orporations because they W ith perhaps the m ost im portant advantage of E dge subsidiaries virtually eliminated, bankers were must agree to observe the same limitations and re strictions as those applicable to Federally chartered Edge A ct subsidiaries. T he prim ary restriction on forced to reevaluate the role of such subsidiaries to determine whether the remaining advantages w a r both types of E dge subsidiaries is that their business ranted their cost— the m ajor cost being a minimum must be confined to international banking and finance. capitalization requirement o f $2 million. Early H istory1 D u rin g the 1920’s th ere w e re 18 Agreem ent and E dge A ct C orporations in the United States, but this number diminished sharply during the depression of the 1930’s, falling to only three at one point. B y the beginning o f W o rld W a r II six T he m ajor advantage remaining was the ability to use E dge subsidiaries to conduct a banking business in d o mestic financial centers across state boundaries from the parent. Out-of-State Edges T h e a d v a n ta g es o f o u t-o f- were in operation, the same number that existed as state E dge subsidiaries have apparently been suffi late as 1959. cient to warrant continued expansion. F ollow in g this long period o f eclipse, O f the 97 however, E dge subsidiaries reemerged in the 1960’s E dge C orporations authorized as of June 30, 1973, to play a prominent role in the present international 42 were w holly-ow ned banking type subsidiaries of banking boom . B y June*30, 1973, there were 97 such organizations, 91 of which were E dge A ct C orpora out-of-state banks. Furtherm ore, there has been an increasing tendency fo r the larger U . S. banks to tions and 6 of which were Agreem ent Corporations. operate more than one E dge subsidiary in financial centers in different parts of the country. A large Primary Advantages E d g e C o rp o ra tio n s have traditionally enjoyed tw o main advantages over other form s of international b an k in g : the ability to conduct an international banking business in a different loca tion from the parent bank, even across state lines and the ability to acquire and hold equity interests in corporations not United States. engaged in business within the C orresponding to these tw o principal advantages, tw o kinds of Edges have e v o lv e d : an in-house holding com pany type and an out-of-state banking type. In 1966, however, the Federal R eserve A ct was amended to permit national banks to invest directly in foreign banks. T his change represented a m ajor erosion in the traditional advantage o f the 1 For a more complete account of the history of international banking in the United States see “ U. S. Banking Abroad” in this Bank’s 1970 Annual Report. international bank, for example, may have E dges in N ew Y ork , Chicago, M iam i, San Francisco, or L os A ngeles, and perhaps H ouston. T he proliferation of multiple E dges by the larger banks has disturbed at least one member o f the Board o f G overnors o f the Federal R eserve System. G over nor A ndrew F. Brim m er was quoted in the M arch 9, 1972, A m erican B anker as fo llo w s : “ I look at inter national financial centers as w indow s on the w orld, but a bank doesn’t need an office in every such w in d o w .” G overnor Brim m er went on to indicate that he saw no need fo r limits on the number o f banks having E dge subsidiaries, particularly if the banks were regional banks operating a unit in N ew Y o rk City. H e apparently believes that every bank is en titled to a N ew Y o r k presence; but elsewhere, he FEDERAL RESERVE BA N K OF RIC H M O N D 15 w ould limit banks to one E dge per region. U nder dom iciled within this District, tw o in V irginia and G overnor States one in N orth Carolina. B rim m er’s proposal, the United O ne of the V irginia E dge could be split into four re g io n s: the Eastern Sea C orporations is operated by its parent bank prim arily board, the W est Coast, the Gulf Coast, and the M iddle W est. U nder this regional concept, banks as a representative in the V irginia ports area; the other V irginia E dge subsidiary operates generally as w ould be limited to the form ation of only one E dge the international department for its parent holding tffeit, on the East Coast, with the exception o f N ew com pany and the subsidiary banks that share in its l$5rk City. ownership. G overnor Brimmer believes that this T he N orth Carolina E dge C orporation plari'Wcmld' help to avoid regional concentrations as is engaged in foreign lending and investing as a well as i^ew Y o rk concentrations o f international supplement to the parent bank’s international activity. b u siA e^ % fth in a select group of large banks. T w o other Fifth District banks ow n m inority inter G overn or B rim m er’s personal proposal points out ests, with 16 other banks, in A llied Bank Interna the dilemma raised by the ability of banks to estab tional, an E dge unit in N ew Y ork . lish E dge A ct subsidiaries across state lines. On the one hand, this ability has enabled the larger re Fifth D istrict banks in the use o f the E dge vehicle gional banks to establish a N ew to provide an out-of-state presence. Y o rk presence, thereby helping to broaden the base of this cou ntry’s international banking structure. O n the other hand, this ability has enabled the huge N ew Y o rk banks to establish E dge units in other areas in order to co m pete with the regional banks on their home ground for their local international customers. W hether greater concentration or decentralization o f the inter national financial business has resulted is not known at this time. It does appear, however, that the estab T his year has witnessed an increased interest by In the early part of this year a Fifth District bank, presently having an E dge unit, opened a second E dge C or poration in N ew Y o rk C ity ; another bank has re ceived permission to do so. Both of these subsidiaries will conduct a general international business. W h ile Fifth District banks are showing an interest in N ew Y ork-based E dge units, there have also been indications by m ajor m oney-center banks o f an inter est in a Fifth District presence. N ew Y o rk banks lishment of E dge subsidiaries in regional centers, have investigated the ports of Baltimore and H am p such as H ouston, for example, has increased com p e ton R oads as possible sites fo r the establishment of tition am ong banks in those locations. E dge C orporations. A fter the Fifth District banks active in initial shock, local bankers have realized that d o the international market should be aware of the possi mestically their national divisions had long been bility of this new com petitive force. com peting with the N ew Y o rk banks for accounts In conclusion, it is fair to say that there is the and that this new entry into the local market for beginning of an awareness by Fifth District banks o f international banking services should make them look to im proving their ow n operations. the need to serve large clients on a national and inter national scale through E dge A ct Corporations in F ifth D istrict P a rticip a tio n W ith in th e F ifth Federal R eserve District, the E dge A ct rush has not yet occurred on a large scale, but there are indica tions of increased interest in the use of this vehicle. A t present only three E dge A ct 16 financial centers other than the parents’ prim ary market areas. It also appears that m ajor interna tional banks have shown some interest in the Fifth District as a potential market area. subsidiaries are MONTHLY REVIEW, SEPTEMBER 1973 D ouglas H . Lem m onds