Why Are Yield Spreads on Bank- Issued Subordinated Notes and Debentures Not Sensitive to Bank Risks? Bhanu Balasubramnian Emporia State University Ken.

Why Are Yield Spreads on Bank-Issued Subordinated Notes and

Debentures Not Sensitive to Bank Risks?

Bhanu BalasubramnianEmporia State University

Ken CyreeThe University of Mississippi

Debt Market Signals

• Yield Spread = f (Term-structure, Default risk, Maturity Risk, Taxes, Liquidity Risk, Systematic Risk,

Unknown factors)

• Yield Spread on Bonds = YTM of a risky bond - YTM of a risk-free bond of similar characteristics

• When leverage (or any other risk measure) decreases, default risk decreases. In turn, yield spread should decrease and vice versa

• Change in yield spreads acts as signal for market perception of change in firm risk or default risk

Debt Market Signals – Empirical Evidence • SND spreads are less risk sensitive during the 1993-97

period and market discipline is weak - Board of Governors (1999)

• Changes in yield spreads are not related to changes in firm-specific risk of banks during 1994-99 - Krishnan, Ritchken, and Thomson (2005)

• Default risk component is large in money-market securities– Covitz and Downing (2007)

• Are the long-term debt markets sensitive to all non-credit risks but not sensitive to credit risks?

Research Questions• Is lack of default risk sensitivity due to omitted credit risk

factors?– Omitted factors of credit risk

– Trust-Preferred Securities (TPS)

– Too Big To Fail (TBTF) effect after LTCM crisis

– Idiosyncratic Volatility

– Omitted factors in decomposition of yield spreads

– Tax effects – Elton, Gruber, Agrawal, and Mann (2001)

• Whether or not TPS yield spreads can be used for market monitoring?

Data Sources• National Association of Insurance

Commissioners (NAIC) database for bond transactions for the years 1994 – 1999

• SDC Platinum database - bond issue characteristics

• FR Y-9C reports for banks• CRSP for stock market data• H-15 Reports from St. Louis Fed for daily

Treasury rates

Sample Selection• Select fixed-rate, U.S. dollar, plain-vanilla

bonds with investment grade credit ratings • No put or call options, collateral, sinking fund• Should not be convertible, Yankee, global,

serial, LBO• Only bank-issued SND transactions• With at least two years of remaining maturity• At least 10 transactions per SND issue• 6620 buys and 4072 sell transactions• 300 SND issues by 71 BHCs

Decomposition of Yield SpreadsYS (i, t) = α + β (F, k) F (i, t-1) + β (M, k) M( t) + β

(L, k) L( t) + β (X, k) X (i, t) + ε (i, t) (1)

• YS (i, t) = Yield spread of bond i at time t • F (i, t-1) = Vector of firm-level default risk variables • M (t) = Vector of market variables • L (t) = Vector of liquidity variables • X (i, t) = Vector of other control variables • Non-linear GMM estimation with Newey -West

(1987) correction for autocorrelation and heteroskedasticity with five lags

Table 4: Firm Specific Variables reflect default risks except ROA  

Variable Estimate p-value

Loans / Total assets (LTA) % 0.4551 0.0001

Non-performing loans / Total loans (NPA) % 7.2025 <.0001

Net charge-off / Loans (CHGOFF) % -9.2037 0.2752

Commercial loans / Total loans (CNI) % 0.2973 0.0038

Off-bal. sheet items / Total assets (OFFBAL) % 0.0200 0.0010

Log (Total Assets) (LNTA) % -0.1130 <.0001

Total Assets / Total Equity (LEVERAGE) % 0.1883 0.0179

Return on Assets (ROA) % 7.6095 0.0198

Market value / Book value (MB) % -0.0853 <.0001

Std. Dev. of stock returns (VOLATILITY) % 0.8886 0.0116

Results – Full Sample

• Yield Spread Levels are sensitive to firm-specific default risk variables

• Tax Effects are significant• Idiosyncratic volatility measure (σ) captures

default risks better than Market volatility measure (VIX)

• Discount for size – TBTF discount• Exception - ROA is positively related to yield

spreads

LTCM Crisis and TBTF Effect

• January 1994 - June 1998 -Pre-LTCM bailout period

• July 1998 – December 1999- Post-LTCM period• Important dates – July 20, 1998, Aug 17, 1998,

September 02, 1998, September 24, 1998 • Major Crises - Mexican (Dec 94), Asian (June

97), Russian and LTCM (Aug 98), Brazilian (Nov 98)

Paradigm Shift in Firm-specific Default Risk Proxies and TBTF Effect

Table 5: Panel C: Firm Specific Variables

VariablePre-LTCM Crisis Post-LTCM Crisis

Estimate p-value Estimate p-value

Loans / Total assets (LTA) 31.7902 0.0076 25.5631 0.3441

Non-per. loans / Total loans (NPA) 475.4882 0.0007 1759.2530 0.0215

Net charge-off / Loans (CHGOFF) 123.5340 0.8924 2764.0580 0.1512

Commercial loans / Total loans (CNI) 15.9458 0.1346 32.4829 0.1587

Off-bal. items / Total assets (OFFBAL) 0.9969 0.1596 2.5581 0.0072

Log (Total Assets) (LNTA) -11.3074 <.0001 -23.2922 <.0001

Assets / Equity (LEVERAGE) 20.5950 0.0118 8.0460 0.6849

Return on Assets (ROA) 277.3742 0.4406 1938.2410 0.0193

Market value / Book value (MB) -6.5626 0.0004 -8.7271 0.0033

Std. Dev. of returns (VOLATILITY) 94.8226 0.0570 -60.8598 0.2945

Default Risk Reduction Due to TPS

• SND issued by all banks as at the end of 1998 $102.8 billion, of which, $100 billion was issued by the top 50 banks

• TPS is the least expensive source of external Tier 1 capital

• Over 800 banks have issued TPS for a total of $85 billion between 1996 and 2004; $28 billion between 1996 and 1999 by the top 50 banks

Leverage is not a significant determinant of yield spread even prior to LTCM bailout but after TPS issuance

VariablePre-TPS Post-TPS pre-LTCM Post-TPS post-LTCM

Estimate p-value Estimate p-value Estimate p-value

LTA 52.1058 0.0005 64.7671 0.0467 13.7311 0.6362

NPA 452.8539 0.0019 262.9285 0.6540 2270.5670 0.0234

CHGOFF) -714.7270 0.5415 -1001.8100 0.6388 2617.7570 0.2406

CNI 2.0294 0.8867 44.9515 0.1169 40.3863 0.1372

OFFBAL 1.3892 0.1068 -0.3551 0.8322 2.3734 0.0153

LNTA -14.8392 <.0001 -12.4138 0.0357 -28.3796 <.0001

LEVERAGE 35.7267 0.0008 27.3064 0.1117 -3.1101 0.8850

ROA 1082.2780 0.0178 548.6316 0.5427 2215.3660 0.0125

MB -18.4576 <.0001 -5.8614 0.0717 -8.1716 0.0118

VOLATILITY -8.2015 0.9096 193.7806 0.0062 -28.9854 0.6205

TPS Spreads are sensitive to on-balance sheet default risk proxies

Variable Estimate p-value

Intercept 415.37 0.0648

Net charge-off / Loans (CHGOFF) 10405.00 0.0646

Off-balance sheet items / Total assets (OFFBAL) -2.08 0.4007

Log (Total Assets) (LNTA) -5.02 0.5397

Total Assets / Total Equity (LEVERAGE) 91.22 0.0128

Return on Assets (ROA) -4087.45 0.0521

No. of observations 58

Adj. R-Sq. 0.5238

F-Statistics 5.18 <.0001

Changes in Determinants of Yield Spreads

• To trace the changes in determinants of yield spreads – Analyze four sub-periods around LTCM crisis

• August 97 – February 98 - tranquil period• March 98 – June 98, the period when bond

market volatility increased • July 98 – September 98, the period when bond

markets became extremely volatile • October 98 - December 99, the post-LTCM

bailout period

Leverage is irrelevant; ROA is a risk proxy; Markets recognize off-balance sheet risks;

TBTF Discount increases

VariableAug97-Feb98 Mar98-June98 July98-Sep98 Oct98-Dec99

Estimate p-value Estimate p-value Estimate p-value Estimate p-value

LTA 0.29 0.3983 1.32 0.1197 0.04 0.9540 0.35 0.2217

NPA -5.03 0.6505 29.84 0.0190 -9.23 0.5279 21.99 0.0081

CHGOFF 57.53 0.6915 42.45 0.5676 24.01 0.6743 54.06 0.0062

OFFBAL 0.00 0.9975 0.01 0.5653 0.04 0.1916 0.02 0.0407

LNTA -0.07 0.4162 -0.15 0.2262 -0.28 0.0695 -0.25 <.0001

LEVERAGE 0.24 0.2974 -0.20 0.6847 -0.71 0.0786 0.34 0.1263

ROA 6.74 0.5700 -15.23 0.0085 -81.11 0.0588 17.80 0.0295

MB -0.10 0.0193 0.06 0.4068 0.12 0.1480 -0.09 0.0090

VOLATILITY 1.67 0.0802 1.95 0.0378 0.74 0.6524 -0.32 0.5930

Monthly Average Yield Spread on BBB-rated SND

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TPS

LTCM

WSJ 04/17/2008–Ahead of the Tape

Results• Yield spread levels on SND are sensitive to conventional risk

measures prior to TPS issuance by banks

• Risk sensitivity of conventional risk measures decrease after the introduction of TPS

• No TBTF effect before the LTCM bailout but size discount doubles after the LTCM bailout

• Idiosyncratic volatility is a better proxy for firm-specific risks

• Omitting the tax effects in yield spreads leads to measurement errors

• Yield spreads on TPS provide market signals

Results

• Bond markets are sensitive to default risks, but paradigm changes in the determinants of yield spreads after LTCM bailout

• Default risk proxies vary with time and available information– Leverage is not a proxy – ROA is a proxy for changes in risk-taking– Off-balance sheet items is a proxy

Policy Implications• Implicit guarantees and market discipline

• Can TPS provide better market signals? – Needs further investigation after TARP

• Disclosure Levels of off-balance sheet items

• Can TPS and SND be capital securities without risk of capital loss?

• Risk-weighting of earnings for CAMELS

Thank You

Questions?

Suggestions?