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December
1960
ON1E· LY REVIEW
Taxes and the
Term Structure of Yields
Corporate Participation in the
Government Securities Market
.
.
page
3
page
9
.
page 15
Index of Monthly Review
Articles for 1960 . . .
page 16
Current Statistics
.
.
FEDERAL RESERVE BANK
OF KANSAS CITY
Subscriplicms lo tlie MoNTIILY REvmw are availahle to the public without charge. Additional
copies of any issue may be obtained from the
Research Departnient, Federal Reserve Bank of
Kansas City, Kansas City 6, Missouri. Permission
is granted to reproduce any material in this
publication.
Taxes and the Term Structure of Yields
IIE TERM STHUCTUHE of yields on outstanding U. S. Treasury securities-that is, the
relationships that prevail between the maturity elates of issues and their yields-is an important aspect of the analysis of the market
for Government debt. It is a significant factor for investors to consider in choosing various issues and it is important lo the Treasury
in 111a11agi11g the dehl. The term structure of
yields also is sig11ifica11l lo <'co11omic and fi mrnc.:ial analysts as an indicator of conditions
in the money and capital markets.
It is not surprising, then, that the yieldmaturity relationship has been the subject of
much careful study. This article is designed
to clarify somewhat the meaning of data used
in the analysis of the term structure of rates
by considering the influence of Federal income tax provisions on the market yields of
outstanding Treasury securities, particularly
those in the 1- to 5-ycar maturity range.
T
The Yield Curve
The maturity pattern of yields on Treasury
debt is most often represented graphically.
On a chart that measures percentage yield on
the vertical axis and number of years to maturity on the horizontal, a point is plotted to
represent the yield ( computed on the basis of
the current market quotation) and term of
each outstanding issue. When all of the relevant points have been plotted, it is customary to fit a freehand curve to the data ( sec
Chart I). This "yield curve" is designed to
summarize the available information by showing the general shape of the scatter of points.
In the preparation of such a chart, care
must be taken to minimize the influence of
Monthly Review •
December 1960
factors other than term to maturity on market
rates of interest. The chart must include only
issues that are highly similar-preferably identical- in all respects save their maturity dates.
For this reason, it is customary to treat callable issues separately and to exclude issues
on which interest income is not fully taxable.
Wide Variations in Intermediate-Term Area
In line with these considerations, the plotted points in Chart I show the market yields
to maturity on only fully taxable, fixed-maturity Treasury securities ( direct or fully guaranteed issues) outstanding on June 30 of this
year. The colored line shows the freehand
yield curve through the points as published
in the August 1960 Treasury Bulletin. 1
The sawtooth line connecting the points
emphasizes the extent of the spreads in yields
obtainable on securities whose maturities do
not differ greatly, particularly in the 1- to 5year area. The differentials that existed on
June 30 were representative, in the sense that
the same general pattern has persisted continuously before and since that date. For the
most part, these extreme variations in yields
on issues of roughly comparable maturities
can be explained on the ground that their
aftertax yields to investors subject to the Federal income tax are not uniquely correlated
with their pretax, or market, yields.
The balance of this article is devoted to
showing how income tax considerations can
1 Because the yield data used here are based on asked
prices, whereas the data in the Treasury Bulletin are
based on bid quotations, the curve shown here is
somewhat lower than that found in the Bulletin.
3
Taxes and the
Cha rt 1
Yields of Marketable Treasury Securities, June 30, 1960
Maturities of 1 or more Years
YIELD IN PER CENT
YIELD IN PER CENT
4.50
4 .50
4 .00
4 .00
3.50
3 .50
3 .00
3.00
FULLY
2 .5 0
L_,l__,l__-'----'----'--'---'---'----L---1---"'----.l_-'----'----'--'--'---'---L--L.---1__.l-
0
5
10
15
YEARS
NOTE: Yield quotations from C. F. Childs and Company.
20
TO
be invoked to explain the wide variations in
market yields, particularly in the 1- to 5-year
area.
Discounted Issues and the Capital Gains Tax
The coupon, or nominal, rate of interest on
a Government security is the percentage that
its regular interest payments bear to its par
(maturity) value. When the general level of
interest rates is higher than the nominal rate
on a particular issue, the issue will trade at
a discount from par sufficient to provide a
buyer with a gain in value to maturity great
enough to make his over-all percentage return
comparable to what he can earn on similar
issues with higher nominal rates. Conversely, issues with nominal rates above the market
trade at premiums over par.
Market yields such as those shown in Chart
1 are determined on the basis of mathematical
formulas that take into account both the regular interest payments and the gain in value
to maturity of discounted issues. Similarly,
the decline to maturity in the value of issues
priced above par enters into the determina4
TAXABLE
ISSUES WITH
FIXED
MATURITIES
2 .50
35
'---.....__.__....___.__-L-____.___.___.____.____.___,____..
25
30
MATURITY
tion of market yields on high-coupon issues.
So long as these computed yields to maturity
form the relevant basis for comparison by investors, the market pricing process will tend
to establish discounts and premiums sufficient to bring the computed market yields
into close relationship with one another for
issues with roughly comparable maturities.
However, for investors su hjcct to Federal
income taxation, net income derived from
buying a discounted issue and holding it to
maturity may differ importantly from the net
income obtained by buying an issue at or
above par. For most investors except securities dealers, holdings of Government securities other than noninterest-bearing obligations issued on a discount basis ( such as
Treasury bills) are classified as capital assets. When such securities are held for more
than 6 months, any gain in their value is
classified as a long-term capital gain. Under
Federal income tax statutes, net long-term
capital gains in excess of net short-term capital losses experienced during a given tax year
are taxed at a rate equal to only one half the
Term Structure of Yields
rate of tax on ordinary income, or 25 per cent,
whichever is lower. In contrast, interest payments are taxed at the full rate applicable to
ordinary income. This means that the investor's aftertax share of a one dollar a ppreciation in the value of a security, when it is taxed
at the preferential rate fo r long-term capital
gains, is greater than his aftertax share of one
doll ar of interest income.
Lower Market Yields on Discounted Issues
If all investors were subject to the same
marginal income tax rates ( i.e. , were in the
same tax l->racket), and all anticipated being
taxed at the lower long-term cap ital gains ra te
on tll<' appreciation in val11c of securities
ho11glit at a disco1111t , market forces could lH'
expec ted to establish a fairly smooth pattern
of tax-adjusted yields. This would imply an irChart 2
Yields On Marketable Treasury
Securities, June 30, 1960
1-5 Years to Maturity
YI E L D IN PER CENT
4 .5
4 .0
3.5
YIE LD
3.0
2 .5
2 .0
I. 5
"TAX- ADJU ST E D" YI ELD
1.0 - ~ - - - . . . . . _ _ - - ~ - - - ~_ _ _.....____,
2
3
4
5
YEARS
TO
MATUR I TY
NOTE : Yield quotation s from C. F. Chil ds and Company.
Monthly Review •
December 1960
regular pattern of market yields, with lowcoupon discounted issues quoted at market
yields below those prevailing on highercoupon issues of comparable maturity.
That the special treatment accorded income
on discounted issues does in fact account for
variations in market yields can be seen by
examining Chart 2, which shows in greater
detail the pattern of yields on issues with 1
to 5 years to maturity. The colored dots in
the upper section of Chart 2 show the market
yields on issues that were trading at discounts
on June 30, while the black dots represent
issues quoted at or above par. It can be seen
that the discounted issues g<'n<'rally carried
lower market yields than did issues of similar
matmity trading at o r above par. This indi cates that taxable investors did , in fact, attach
a greater value to the income derived from
the gain in value of these issues as they reach
maturity. But it need not imply that market
forces brought about a smooth pattern of "taxadjusted" yields, i.e., aftertax yields computed
on the assumption that the gains to maturity
are taxed at the preferential rate.
For one thing, tax-adjusted yields are not
the same for investors who are not subject to
the same marginal tax rates. This point has
some importance. For investors in low tax
brackets, the tax advantage of net Jong-term
capital gains income relative to interest income is less pronounced than it is for highbracket taxpayers. This is illustrated by Chart
3, which shows, for the various marginal rates
under the Federal income tax, the aftertax
value of $1 capital gains taxed at the preferential rate relative to the aftertax value of $1
ordinary income. For example, an individual
investor in the lowest ( 20 per cent) tax bracket can keep $.80 of every $1 of interest income and $.90 of every $1 of net long-term
capita] gains. In this case, $1 of capital gain
taxed at the preferential rate is worth, on an
aftertax basis, $1.00( .90/.80) = $1.12½ of interest income. At the opposite extreme, the
s
Taxes and the
Chart 3
Ratio of Aftertax Value of $1 Long-Term
These yields are computed on the assumption
that regular interest payments are taxed at
the 52 per cent rate applicable to corporation
net income in excess of $25,000, and that the
gains to maturity of discounted issues with
more than 6 months to run are taxed at the
maximum rate of 25 per cent applicable to
long-term capital gains. In Chart 2, the taxadjusted yields for corporations on Treasury
issues with 1 to 5 years to maturity as of June
30, 1960, are shown by the scatter of x's that
lie directly below the dots which represent
computed market yields for the same issues.
Just as the pattern of pretax, or market,
yields is highly irregular, so is the scatter of
Capital Gains Income to Aftertax
Value of $1 Ordinary Income
For Various Marginal Tax Rates
RATIO
8 -
6
4
11
0
20
I 11,111
30
40
50
uill l~
60
70
.L..I..L..-A--L&a.
80
90
100
MARGINAL TAX RATE (PER CENT)
individual investor in the highest ( 91 per
cent) bracket finds that $1 of long-term capital gains taxed at the maximum 25 per cent
rate is the equivalent, after taxes, of $8.33 1/3
of ordinary income.
It is therefore not possible to speak in terms
of any "representative" relationship among
tax-adjusted yields for taxpayers in general.
Market forces arising out of the decisions of
tax-conscious investors, although they may
tend to lower the market yields of discounted
issues because of the premium attached to
capital gains income, nevertheless produce an
ambiguous pattern of rates which represents
only some kind of consensus. However, the
great importance of corporations ( including
commercial banks) among the active participants in the Government securities markets
leads to the presumption that whatever consensus is arrived at will reflect in large measure the viewpoint of corporate taxpayers.
Tax-Adjusted Yields for Corporations
As a service to their corporate customers,
Government securities dealers regularly quote
yields on a tax-adjusted basis for corporations.
6
tax-aclj11slcd yields lo corporations. Tlw high est tax -adj11sl<'d yields were gc11crally obtainable on issues trading at discounts , shown hy
the colored x's.
Clearly it cannot be said that the consensus
of taxpaying investors, insofar as it was dominated by the corporate view, was such as to
produce a uniformly rising pattern of taxadjusted yields in the 1- to 5-year maturity
area. Evidently there were forces that kept
tax-adjusted yields on issues trading at or
above par from rising to levels comparable
with such yickls on cliscountccl issues.
Segmentation of the Market
A plausible explanation of the diverse
patterns of yields on both the market and the
tax-adjusted basis is that there are really two
markets for Government securities when some
issues trade at a discount, because not all investors ( for example, those not subject to
taxes) attach a premium to capital gains. Note
that in Chart 2, the black line drawn to connect all of the black dots which show computed market yields on non<liscounted issues
traces a reasonably smooth progression of
market yields from one maturity to another.
The issues included on the black line, together
with those few discounted securities represented by colored dots that lie close to the
Term Structure of Yields
line, would comprise the relevant market for
those investors who do not attach special importance to capital gains income.
Other investors, to whom capital gains are
more attractive than interest income, are willing to buy and hold certain discounted issues
at prices that keep their market yields well
below those shown along the black line. These
gains-conscious investors would choose from
among the issues with the highest tax-adjusted
yields, shown by the x' s that are connected by
the colored line in the lower part of Chart 2.
Viewing the yield data in this way lends
support to the hypothesis that the market for
Government clchl is segme11lccl when some
issues lraclc al a substantial cliscou11l. The
two patterns, imlicalcd hy the hlack a11d colored lines, both show a reasonably smooth
progression of yields from one maturity to
another. All issues fall into at least one of
the patterns-deep-discounted issues, whose
tax-adjusted yields are highest relative to their
market yields, are in line only on a tax-adjusted basis. Some issues trading at more moderate
discounts are also in line only on a tax-adjusted
basis. However, at least two moderately discounted bonds ( shown by the arrows) are
attractive on either basis. Finally, two discounted issues, one with nearly 4 years to
maturity and the other with slightly more
than a year to run, are clearly more attractive
on a market-yield basis than on a tax-adjusted
basis. Both of the latter issues were priced
on June 30 at very small discounts from par.
Limited Relevance of Tax-Adjusted Yields
The precise yield relationships that emerge
in such a segmented market will depend on
the relative strengths of the two investor
viewpoints. In general, the more predominant is the tax-adjusted view, the lower will
be the market yields on discounted issues relative to issues trading at or above par, and
the higher will be the tax-adjusted yields on
nondiscounted issues relative to those on isMonthly Review •
December 1960
sues trading below par. If the tax-adjusted
viewpoint were sufficiently strong to dominate the entire market, yields on all issues
would fall into line on a tax-adjusted basis.
The tax-adjusted view is not likely to dominate the market, however. Investors not subject to Federal income taxation, including
state and local government units, pension
funds, charitable and religious organizations,
and credit unions, would concentrate on issues
carrying high market yields. In addition,
taxable investors who did not anticipate recording net taxable income in future years
would not attach a premium to capital gains
ancl would therefore make their investment
choices 011 the hasis of comparative market
yields. This latter group might include many
savings and loan associations and mutual savi11gs banks, which often do not experience
net income subject to Federal income taxes.
In addition, several factors not taken into
consideration in the computation of tax-adjusted yields may bear importantly on the decisions of taxable investors. The most significant qualification to be made is that the
tax-adjusted yields are accurate predictions
of aftertax yields only on the assumption that
the preferential capital gains rate is certain
to apply to income arising out of the increased
value of securities now selling at discounts.
However, it is possible that the years in which
the gains on presently discounted securities
are realized will not be years when net longterm capital gains exceed net short-term losses. It will be recalled that an investor is required to deduct his net short-term losses from
his net long-term gains to arrive at the amount
of long-term gains subject to the preferential
tax. Therefore, the tax-adjusted figure applies only if an issue purchased presently at
a discount is sold or redeemed in a year when
the investor experiences net long-term gains
in excess of net short-term losses.
Should the gains be realized in a year in
which the investor experiences capital losses
7
Taxes and the Term Structure of Yields
in excess of his long-term capital gains, the
actual aftertax yield will differ from the computed tax-adjusted yield. The nature of the
difference cannot be specified without considering the circumstances of the investor.
For banks, long-term capital gains income
has no advantage over interest income if it
is realized in a year when losses exceed gains.
This is because banks can deduct net securities losses from ordinary income without
limit. Offsetting realized gains against realized losses raises the amount of income taxable at the ordinary rate, so that the "effective
rate" on long-term gains is the same as that
applied to ordinary in come. For this reason,
many hanks systematically attempt to rccor<l
long-tcnn gains only in years when they exceed securities losses.
But banks c'lnnot generally be certain
whether a given future year will be a "gains
year" or a "loss year," so that the choice of
the relevant yields to be considered in making
portfolio selections is not clear-cut-if a bank's
management buys securities with high taxadjusted yields, it presumably looks forward
to the distinct possibility of being able to
benefit from the preferential treatment of net
long-term gains. But another bank, identical
to the first in all objective respects, might
choose an adjacent issue with a higher pretax
yield and a lower tax-adjusted yield with the
expectation that the gains that accrue on discounted issues will be realized in a loss year.
The problem is more complicated in the
case of most other investors, because they are
allowed only limited deduction of net capital losses. Net capital losses of most individual
investors can be offset against ordinary income in any year only up to a maximum of
$1 ,000, while most nonbank corporations are
not allowed any deduction of net capital
losses from ordinary income. Although unused net losses may be carried forward for as
many as 5 years, the restricted deductibility
may nonetheless make it particularly advan-
8
tageous for nonbank investors to record capital gains in years when heavy losses are experienced; when capital gains can be offset
against unused capital los5es, the effective
rate of tax on the gains is zero. The contemplation of this possibility adds to the attraction of capital gains income, and thereby
heightens the attraction of discounted issues
to most taxable nonbank investors. This contrasts sharply with the case of commercial
banks.
Concluding Remarks
Obviously, this complex dependence of the
actual aftertax yields on imperfectly predictable events greatly complicates the considerations entering into choices of taxable investors among discounted issues and those trading at or above par. When activity in the
market is heavily influenced by preferences
for capital gains income on the part of taxpaying investors ( particularly commercial banks),
one would expect the spreads between computed market yields on high- and low-coupon
issues with similar maturities to be accentuated,
bringing tax-adjusted yields into closer relationship with one another. Similarly, when
investment decisions are heavily influenced
by the view that no special benefits will attach to capital gains income, it can be expected that the pattern of market yields on various issues will tend to be smoother, with taxadjusted yields showing the greater variations.
As long as significant numbers of investors
view the value of income from appreciation
of discounted issues differently-some favoring it over interest payments and others
weighing it equally with interest income-the
market is likely to be segmented into two
parts. Under such circumstances, there are
likely to be two yield curves, one showing
relatively smooth patterns of market yields to
maturity on non<liscounted issues and the
other displaying a fairly smooth pattern of taxadjusted yields on most discounted securities.
Corporate Participation
•
1n the Government Securities Market
of short-term liquid assets, at least over the past decade,
has involved holding cash balances that
would meet the requirements of the firm ancl
using other liquid <'art1i11g assets to ahsorh the
<'hh and f1ow of funds through corporate ac
C
onPORATE MANAGEMENT
counts, thus s11pplcn1cnting corporate cam
ings. Assds which have been 11sed for this
purpose have bec11 short-term Treasury securities, loans to sales finance companies, time
certificates of deposit at commercial banks,
and loans to Government security dealers on
repurchase agreements. Of these assets, Treasury securities have been of greatest importance. At times, corporate liquid asset management has been described as showing an
increasing interest in holding short-term earning assets, either as an absolute amount or as
a proportion of total Jiquicl assets. The relative amounts of cash and Treasury securjties
held also have been d escribed as involving
a secular trend and as varying through the
several phases of the business cycle.
The liquid asset management of corporations has evoked the interest of a variety of
observers of economic developments. Analysts of credit markets have given close study
to corporate holdings of Treasury securities,
probably for h-vo principal reasons. First, conditions which might alter these holdings suhstantially would have significant effects upon
market rates of interest and the prices of securities. Second, unusually large accumulations of such investments might foreshadow a
marked growth of corporate outlays for plant,
Monthly Review •
December 1960
equipment, and inventory , while exceptionally
small holclings might retard these outlays until liquid asset positions had been restored to
more acccptahk levels.
The interest of students of <'Cntral hanking
and financia I inst it11t ions in corporate man agement of liq11id assets also has been stirnu -
lated by its implications for rn011etary policy
aud credit controJ. One line of analysis which
has been advanced states that the composition
of corporate liquici asset holdings is sensitive
to changes in market rates of interest. As
interest rates on Treasury bills increase, corporations are said to reduce their holdings of
cash and increase their investment in bills
and to reverse the position when rates decline.
When a monetary policy of restriction on the
growth of total bank credit is in cff ect, hanks
meet growing d('mands for loans hy selling
short-term Treasury securities, which reduces
deposils and raises excess reserves, thereby
allowing the demands to be accommodated.
These sales depress the prices and raise the
yields on Treasury bills, attracting corporate
and other investors into the market. The cash
that is relinquished when securities are bought
is said to be "idle" in the sense that those who
reduce their cash balances do not reduce their
current expenditures correspondingly. Consequently, the process as a whole is thought to
transfer idle balances to thos(' who will use
them actively, and the turnover of money is
increased, offsetting in part the restriction on
the growth of total demand which monetary
policy was designed to exert.
9
Corporate Participation in the
These groups of interests raise a number of
problems for analysis, at the heart of which
is the identification and evaluation of the
forces associated with changes in corporate
ownership of cash and Treasury securities.
Other types of liquid assets serve the same
purposes as Treasury securities, but their position among corporate assets has been less
important. The interest of credit market analysts outlined above pertains particularly to
corporate activity but the hypothesis that relates cash holdings to interest rates involves
the behavior of all holders of cash balances,
and corporations represent only one of the
major segments. Therefore, any findings either
in s11pporl of or i11 co11Lradidio11 lo the hypothesis cannot he generalized as applying Lo
the whole economy.
The ensuing c.liscussion first wilJ examine
changes in corporate cash and Treasury security holdings over recent years to determine
whether the magnitude and timing of their
fluctuations confirm the assumptions which
have been made about them. The next section
will seek to isolate the major forces which are
associated with fluctuations in the distribution
of corporate liquid assets. The final section
will interpret the results in the light of the
problems outlined ahove.
Chart 1
Cash Balances of Corporations
BILLIONS
OF DOLLARS
38
34
ALL
CORPORATIONS
26
18
MANUFACTURING
CORPORATIONS
14
0 '-'--...J._j-'--'-l.-'--'-'--'-l.-'-L.L...L..I._..L.._.L_j____l_j- ' -..L.J..-'-L.L..L.l._L_.L.J
1953
•54
•55
'56
•59
•57
'58
'60
10
Chart 2
Treasury Security Holdings as a Percentage
of Securities and Cash Held
PERCENTAGES
PER
CENT
55
6 . 00
50
5.00
45
4 .00
40
3.00
35
?. .00
30
I 00
0
...L..I.
1953
l_,_1. I
'54
1
l...L -'--
'55
I
j_
.I
'56
J
~
l
_J_
'57
L . L...l
1
'58
Ll
1 L l
'59
1
l.
0
'60
Corporate Cash Balances and Treasury
Security Holdings
Some of the hypotheses about corporate
cash halanccs and Treasury security hole.lings
can be tested in a preliminary way by a
straightforward examination of data for recent years. Chart 1 displays the data for the
cash balances of all U. S. corporations other
than banks and insurance companies and for
U. S. manufacturing corporations. Since both
of the series arc marked by strong seasonal
patterns, a 4-quartcr moving average is drawn
through each to eliminate the seasonal influence and lhus to reveal trend and cyclical
components.
The adjusted data for all U. S. corporations
exhibit a clearly defined upward trend from
19.53 to midyear 19.59, while the adjusted data
for manufacturing companies were approximately stable or tending downward slightly.
The minor cyclical movement observed in the
data for all corporations generally coincided
with periods of expanding business volume.
There were only two i11stances of declines in
the adjusted balances of all corporations, one
of $100 million in 1957 and the other of $500
million in 19,59-60. The seasonally adjusted
series for manufacturing companies shows a
mild cycle characterized by increases ranging
Government Securities Market
Changes In Cash and Treasury Securities Owned
In billions of dollars
Period
June '54-Dec. '55
Dec. '55-June '58
June '58-Dec. '59
All Corporations
Treasury
Securities Cash
+6.2
-9.1
+9.6
+4.5
-- 0.2
+2.8
from $400 million to $,500 million and a decline of about $800 million.
Since the most conspicuous changes in corporate cash balances arc the seasonal rnovenwnts , these fluctuations were examined for
cvidc11cc that their amplitude was related to
periods of high ,111d low i11lcrcsl rates. Tlw
i11vcstigati011 did 11ol 1111<·ovcr a11y i11dicalio11
of such a rclatio11ship.
As corporate cash balances arc relatively
stable through the business cycle, it is evident
that variations in total corporate liquid assets
must be reflected in other assets. Chart 2 presents one of these-Treasury securities-as a
percentage of total cash and Treasury securities held by all corporations and by manufacturing corporations together with quarterly
averages of the rates on newly issued 91-day
Treasury hills. A proportion was usecl rather
than the absolute level of sec.;urity holdings
because it was desired to relate the rising
volume of cash balances held by all corporations to their security investments.
Over the period as a whole, neither of the
series displays any clear evidence of a secular
shift from cash to Treasury securities. Since
all corporations held the same proportion of
securities at the end of 1959 as they held in
195,5, it is evident that the absolute level of
their portfolios grew in proportion to their
cash balances. Both series show a rising proportion of securities from 19,54 to 19.55, a declining proportion from the last quarter of
19.5.5 to the second quarter of 19.58, and a rising proportion again from 1958 to the end of
1959.
Monthly Review •
December 1960
Manufacturing
Corporations
Treasury
Securities Cash
+5.0
- 6.5
+5.6
+1.0
-0.6
- 0.1
Nonmanufacturing
Cor~orations
Treasury
Securities Cash
+1.2
- 2.6
+4.0
+3.5
+0.4
+2.9
The fact that manufacturing corporations
held a much greater proportion of securities
than all corporations means that securities are
much less important in the portfolios of nonmanufacturing corporations. The accompanying table also indicates thC' extent to which
<'acl1 of tll(' corporate groups employed cash
and Trcas11ry sccmitics i11 making tlicir ad justments lo seasonal and cyclical swings during HJ.5..t-.59.
Two possible interpretations might he given
to this disparity in the operations of the two
corporate groups. One is that manufacturing
operations have characteristics that permit a
closer scheduling of receipts and disbursements than can be achieved by corporations
in general. The other is that the typical manufacturing firm possesses greater total assets
than the average of all companies and its cash
resources therefore arc large enough to justify
transferring excesses to the securities market.
lf the influence of some of the communications companies were deducted from the nonmanufacturing group, it is probable that the
remainder would show a still lower volume of
Treasury securities and smaller changes
through the business cycle.
Factors Affecting Distribution of Liquid Assets
It is apparent from the above discussion
that variations in corporate investment in
Treasury securities arc not produced to any
measurable degree hy shifts out of cash balances hut arc related to variations in total
liquid assets that accompany seasonal and
cyclical movements of business activity. It is
11
Corporate Participation in the
therefore necessary to consider next the
changes which lead to variations in these
requirements.
One of the better-known aspects of corporate financial management is the fact that
many firms follow a practice of altering their
investment in Treasury securities as changes
occur in their Federal income tax liabilities.
That these requirements are not fully covered
by all companies is evidenced by the bulge in
business borrowing from banks at the quarterly income tax payment dates. The companies that do follow the practice appear to
have a number of rc>asons for their choice.
One that is applicable to the motor vehicle
(·ornpa11i<'s a11cl olh<'r eq11ip11w11l producns
which have sales credit affiliates is that the
parent and the affiliate are counted as a siHgle
borrower at banks. Since banking laws generally limit the amount of loans to one borrower, the credit line is left by the parent for
the use of the affiliate. It is also possible that
bank lines are reserved for requirements that
are of longer duration than those growing out
of tax payments.
Corporate accruals of Federal income tax
liabilities fluctuate as a result of changes in
corporate profits and tax payments, if legal
tax rates arc> constant. In relation to the business cydc, corporate profits typically expand
rapidly in the early stages of recovery and
then show little further growth or may decline as general activity continues upward to new levels. This pattern results from
the rapid rise of productivity in the early
stages of recovery when costs are advancing
more slowly. As gains in productivity become
more difficult to realize, costs encroach on
profits. Tax payments lag behind changes in
corporate income tax liabilities, although the
acceleration of these payments ovc>r the pc>riod
since 19.50 as a resu1t of changes in tax laws
has shortened the interval and tended to reduce the volume of corporate accrued income
taxes. These interrelationships produced a
12
peak in accrued taxes in 1955, after which an
irregular decline occurred until the second
quarter of 1958. Accruals again advanced until the fourth quarter of 1959 but failed to
reach the level of 19,55 because of the acceleration of tax payments.
A second relationship which modifies the
liquidity requirement of firms is the difference in cyclical timing between the expansion of profits and the growth of business investment. The early increase in corporate
profits , previously described, leads to a
marked increase in retained earnings as corporate clivicl<'ncls arc raisecl more slowly. On
the olh<'r l1a11cl, h11sincss capital expansion
programs follow a somewhat diff('lTlll pattern
i11 r<'blio11 to 1H1si11<'ss cycles. l11ventory usually responds quickly to the growth of sales
but outlays for plant and equipment reach
their peak late in the prosperity phase. Depreciation allowances - a second internal
source of funds - show a secular increase as
a result of the expansion of aggregate corporate investment in plant and equipment.
In the interval between the growth of depreciation and retained earnings and the dishursc>ments of fonds for new capital, cash
balances would accumulate unless other shortterm assets were availahle or unless debts
could he liquidated. The relationship between
net internal sources of funds of manufacturing corporations and their liquid asset holdings is ath·ibutable largely to the absence of
short-term debts among the largest of the corporate investors. Cases in point are the motor
vehicle, primary metal, chemical, and petroleum industries. In such cases, there is no
good alternative to acquiring short-term assets
whenever cash flows expand more rapidly
than disbursements for capital. During the
stage of declining business volume, retained
earnings contract as docs investment in plant
and equipment hut depreciation allowances
and liquidation of inventories lead to net additions to corporate liquid assets.
Government Securities Market
Chart 3
Selected Items Related to Treasury Security
Holdings of Manufacturing Corporations
BILLIONS
OF
DOLLARS
PER CENT
20
5.00
TREASURY
16
4.00
12
3.00
2.00
4
1.00
'
NET INTERNAL
SOURCES OF FUNDS
0
- 4
_ 1 J
J
1954
I
J [_ J
'55
I
1
l
l
'56
l
I 1
'57
Ll
.1 J.._1
'58
.I
1... 1
0
LG l .1J.. J
'59
'GO
1
I
'61
ln order to indicate the general intcrn·lationships of these variables and Treasury security holdings, Chart 3 presents the data for
manufacturing corporations. A similar display
could not be prepared for all corporations because the data on retained earnings, depreciation, and investment in inventories, plant and
equipment were not available. Values for the
line which is designated "net internal sources"
were obtained by cumulating the differences
between depreciation and retained earnings
as one term and changes in inventory plus
out1ays for plant and cq11ipment as the other.
The plant and equipment outlays were those
of the Department of Commerce rather than
the values shown in the Quarterly Financial
Report of Corporations, since the latter would
be affected by accounting practices in treating
capital lost through damage or destruction,
and in charging a part of these outlays to
current expense. The net internal sources
term was cumulated successively from 1954
onward since both Treasury security holdings
and accrued taxes arc cumulative terms. Alternatively, the internal sources variable without cumulation could have been related to
quarterly changes in security holdings and accrued taxes but this procedure would have
Monthly Review •
December 1960
obscured the cyclical characteristics of the
three series which are of primary interest.
A general cyclical conformance of the compound term and the Treasury security holdings of manufacturing companies is apparent
in Chart ,3, but the former turned down one
quarter earlier in both 19.5,5 and 1959 than the
securities series and began to rise two quarters earlier at the 1957-.58 low point.
Inspection of the chart suggests that the
Treasury security holdings of manufacturing
corporations were strongly affected in the
period studied by variations in accrued Federal income tax liabilities and net internal
sources of fttncls, hut the influence of variations of i11tncsl r;llcs is not clear. 111 order to
cor11hi11e th<'sc three factors i11lo a single csli mate of clia11gcs in security holdings, a mul tiple regression analysis was applied to the
data. It was also the purpose of the analysis
to try to determine more exactly the role
which interest rates played in accounting for
the changes in security holdings, particularly
since their behavior is central to several current analyses of the effectiveness of monetary
policy. The estimates produced by the analysis are shown in Chart 4 and the statistical
characteristics arc set forth in the appendix.
Since the estimates conform rather closely to
the original data , it is evident that the three
variables combined account for most of the
fluctuations in the Treasury security holdings
of manufacturing corporations.
Summation of the Evidence
The regression analysis indicated that most
of the fluctuations in the Treasury security
holdings of manufacturing corporations from
19.54 to 1960 were accounted for by the coml)inccl influence of changes in accrued Federal
income taxes and in the cumulative difference
between internal sources of funds and real investment. If an estimate of Treasury securities had been made on the basis of accrued
taxes alone, 39 per cent of the variance in the
13
Corporate Participation in the
Chart 4
Treasury Securities of Manufacturing Corporations
BILLIONS OF DOLLARS
BILLIONS OF DOLLARS
16
16
14
14
12
12
10
10
1954
'55
'56
'57
securities series would have been explained.
The addition of the net internal sources variable explained 86 per cent of the remaining
variance. If the procedure had been reversed,
approximately the same result would have
been obtained. Therefore the two series were
equally important in accounting for variations
in Treasury securities. Use of the two variables together explained 91 per cent of the
variance in Treasury securities. The amount of
remaining variance which is explained by interest rates was 11 per cent, indicating that
interest rate movements were of relatively
minor significance in explaining the policies
of manufacturing corporations in the aggregate.
Yet there are reasons why the influence of
interest rates upon the composition of corporate liquid assets cannot be dismissed. The
disparate behavior of all corporations and of
manufacturing corporations in the relative proportion of cash plus Treasury securities held
in the form of securities suggests the possibility that the size of the firm may have a
significant influence upon the kind of liquid
14
'58
'59
'60
assets held. If this should be the case, then
the influence of interest rate movements may
be exerted primarily on smaller firms which
are at the margin in terms of whether they
hold cash or securities. This interpretation
would be consistent with the results of the
regression analysis, since the behavior of the
smaller firms would be largely overshadowed
by the actions of larger firms whose liquid assets arc much greater.
But such an interpretation also means that
firms with substantial liquid asset holdings
would have found it advantageous to minimize their cash holdings in order to hold earning assets at all rates of interest that existed
during the period reviewed. Therefore, their
holdings of Treasury securities should exhibit
no cyclical response to rates.
A cliffcrcnt possible rdationship between
corporate cash management and interest rates
is that high rates may lead to improvements
in internal controls and procedures that yield
their benefit over longer periods of time, making it possible for a rising volume of business
to he conducted without proportionate in-
Government Securities Market
creases in cash. Changes of this kind would
be of a secular character and would only mean
that the growth of the money supply appropriate to growth of total output could be
lower than otherwise.
From these observations, it follows that corporations appear to be among the less significant groups which furnish cash balances to
the market in response to rising interest rates.
It is possible therefore that any general shifts
in the ownership of deposits as a result of rate
movements would be exhibited more clearly
by other institutions and by individuals.
STATISTICAL APPENDIX
Th<' r<'gn·ssion analysis c·111ploycd tlH' following
vari:1hl<'s:
Tr(':tS111y S('('Jtrili<'S h('ld by 111a,11dact11ii11g ('01
poralions <'\pn ·swd in tens of millions of dollars .
x,
accrued F<'d<'ral incolll<' lax liabililies of these
companies express<·cl in lens of millions of dollars.
X3
cumulative difference between deprecialion and
X:!
=
retained earnings as a source of funds and changes
in inventory and outlays on plant and ec1uipment as
the demand for funds, expressed in millions of dollars.
X 4 = average rate on 91-day Treasury bills.
The analysis gave the following results:
x 1 = 288.94+0.1924x 2 +0.0353x:1 +11.s9x 4 _
Slanclard error of the equation
28.6
Standard error of b,, = .0768
Standard error of b; = .0031
Standard error of b.a = 11..53
Rl.234 = 0.96
rl2.34
0.92
r 13.24 = 0.93
rl4.23 = 0.33
The equation mel the Durbin-\Vatson test for
serial correlation al lhc> 1 per cent level of signifi<·,mc<', hut evid<'nce of sc>asonality in the residuals led
lo fmlh<'r l<'sls . \Vlicn lax pay111('nls ( X,,) and
('ha11g('s in ('ash bal:lll( '('S ( x(I) W('r(' :1dcl('d, tlH' <'Vi
=
=
d<'n<'<' of s1·aso11;tlity was <'li1ninal<'cl . Sinn• th<' adcli
lion of lh<'se lwo variables inncas<'d the <'odfici1 •11t of
m111Liple correlation only to 0.985, the dis<'11ssion was
c.:onfincd lo the case of the three independent vari-
ables.
BANKI NG IN THE TENTH DISTRICT
Loans
Deposits
Reserve
District
PRICE INDEXES, UNITED STATES
Reserve
City
Country
City
Country
Member
Member
Member
Member
Banks
and
Banks
Banks
Banks
Sept. Oct. Sept. Oct. Sept. Oct. Sept. Oct.
1960 1959 1960 1959 1960 1959 1960 1959
Colorado
Kansa s
+1
+2
t
+12
+3
+3
+2
+5
t
+4
-1
+13
+3
+4
+1
+6
+5
+6
t
+18
+3
+1
+1
+7
+8
+10
Missouri*
+3
+7
t
Neb raska
t
- 6
+2
New Mexico*
Oklahoma*
Wyoming
Sept.
1960
Oct.
1959
125.5
Consumer Price Index
(1947-49=100)
127.3
126.8
Wholesale Price Index
(1947-49 = 100)
119.7
119.2
119.1
Prices Rec'd by Farmers
(1910-14- 100)
240
237
235
Prices Paid by Farmers
(1910-14
297
298
296
100)
October 1960 Percentage Change From
States
Tenth F. R. Dist.
Oct.
1960
Index
+4 +4 +4
+5 +2 +5
+3
-1
0
+8
+1
+2
-4
4
- 15
- 14
0
+3
- 4
+2
+1
Oklahoma City
- 5
+1
Tulsa
0
0
- 4
-4
- 3
+9
+ 1
+3
+1
+9
**
**
+5
+4
*Tenth District portion only.
t less than 0.5 per cent.
+2
+10
+18
- 3
t
Year
to date
+2
-1
**
Oct.
-1
**
**
Year
to date
Omaha
- 2
+13
Oct.
Wichita
**
+4
Percentage change-1960 from 1959
Areas
Tenth F. R. District
Value of
Department
Store Sales
Value of
Check
Payments
+3
+1
**
District
and Principal
Metropolitan
Denver
+4
+4
+4
**
TENTH DISTRICT BUSINESS INDICATORS
Kansas City
0
**No reserve cities in this state.
Monthly Review • December 1960
15
JnJex o/
MONTHLY REVIEW olrticlei /or 1960
Article
Agriculture
Article
Issue
Agricultural Growth and
the Rural Economy ( 6 pages) ............ June
Agricultural Outlook for 1960
( 6 page's) ........... .. ..
.... ...
B11ttcr- The "Balance Wheel"
of an Industry ( .5 pa ges)
January
February
Cattle Numbers and
Beef Production ( 6 pages) ... . ......
March
Is the Farm Real-Estate
Boom Ebbing? ( 6 pages ) ........................ July
Rural Development Program
( 6 pages) .................... ................... September
The Wheat Surplus Problem
( 7 pages) . ... ...... ...................
November
Issue
Interrelationship of Monetary
and Fiscal Policies ( 7 pages) ....... February
Liberalization of World Trade
and Payments ( 8 pages) ............... .. May
lkccnt Developmen ts in District
Hank Liquidity ( 6 pages)
May
Hcsidcntial ~fortgagc Market
in HJ.59 ( 6 pages) ............................... April
Taxes and the Term Structure
of Yields ( 6 pages) ........................December
Industry an d Trade
Changing Patterns in
Economic Expansion ( 7 pages) .... January
Banking and Finance
Export-Local Employment
Helationship in MctropoJitan
Areas ( 7 pages) ....
. .................. ..March
Bank Reactions to
Securities Losses ( 8 pages) .... ....... .. .June
Lahor Force Growth in an
Expanding Economy ( 8 pages) . September
Changes in the Use of Consumer
Instalment Credit-Implications
for 1960 ( 8 pages) ...................... .............. April
Recent Adjustments in
Petroleum Refining ( 6 pages) ........ October
Corporate Participation in the
Government Securities Market
( 7 pages) . ... ..............
.December
Financing of Federal
Lmding Agencies ( 7 pages)
November
Growth and Earnings at Individual
Commercial Banks ( 7 pages) .. . ... ....July
16
Recent District Industrial
Developments ( 6 pages) .................... August
State' and Local Government
Activities- District and
National Patterns ( 7 pages) .... ... .August
State and Local Government
Activities in the
Tenth District ( 7 pages) .................. October
@FedFRASER