should corporates issue iibs
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8/12/2019 Should Corporates Issue IIBs
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LIONEL MARTELLINI ANDVINCENT MILHAU LOOK AT INFLATION-LINKED BONDSIN THE CORPORATE WORLD.
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Arecent surge in inflation uncertaintyhas whetted investor appetitefor appropriate hedges. Inflationhedging is now of critical
importance to pension funds (pensions areoften indexed to consumer price or wageindices) as well as private investors.
Inflation-linked debt is still most closelyassociated with sovereign states, but state-owned agencies, municipalities andcorporates utilities and financial servicescompanies, in particular are alsoexpressing interest in it. In fact, intuitionsuggests that if revenues grow withinflation, then issuing some inflation-linkeddebt can be a natural hedge.
Yet some large corporates still do notissue inflation-linked bonds, in part perhapsdue to the common belief that debtmanagement should be governed by thedesire to reduce the cost of debt financing.In particular, the standard argumentsuggests that a company should seek toissue fixed-rate debt if it expects an increasein interest rates and floating-rate debtotherwise. A similar intuition suggests itshould issue nominal bonds if it expects anincrease in inflation and inflation-linkedbonds if it expects a decrease.
In this context, inflation-linked bondswould not seem attractive from the issuersperspective, since the cost of debt servicingwould be expected to increase withinflation. This seemingly straightforward lineof reasoning suffers, however, from one fatalflaw: the difference between fixed andfloating (versus real) rates merely reflectsmarket expectations and a risk premium.
Consequently the only non-trivial impactmay come from the chief financial officersactive views if they deviate from marketexpectations. In the end, the purpose of a
company is arguably not to make profits bytrading in financial markets.
THE RELEVANCE OF DEBT MANAGEMENTIn recent research1, we introduced a generalframework to help a company subject todefault risk to make optimal debtmanagement decisions. We attempted toanswer the following question: given anexogenous revenue process for a company,what is the optimal liability structure whenthe issuer faces such instruments as fixed-rate debt, floating-rate debt and inflation-linked debt? In fact, this problem is theexact counterpart of the standardasset/liability management problem for apension fund, in which liabilities areexogenously given while it is the allocationdecision that is optimised.
Although the theory of asset allocationdecisions is relatively well understood, theunderstanding of liability management iscomparatively limited. Our researchpresents an initial joint quantitative analysisof capital structure and debt managementchoices in a unified framework.
A FORMAL CAPITAL AND DEBTSTRUCTURE MODEL We show that debtmanagement decisions can be formallyanalysed in the context of a dynamic capitalstructure model, with a trade-off betweenthe (bankruptcy) costs and (tax shield)benefits associated not only with leveragebut also with debt structure decisions. To doso, we abstract away from problems of agency and asymmetric information, andconsider competing forms of liability classes
(fixed-rate bonds, floating-rate bonds andinflation-indexed bonds, as well as equity) ina relatively rich stochastic environmentinvolving interest rate and inflation risks.
Although the non-independence of default risk and interest rate risk turns outto be a great complication, we have beenable to obtain quasi-closed-form expressionsfor the price of both indexed and non-indexed defaultable bonds by focusing on asetting in which the distance to default is alog-normal process. The presence of thesequasi-analytical expressions allows us togenerate computationally efficientestimates for the optimal debt structure.
Our research shows that if they are toincrease shareholder wealth the companysmanagers should seek to immunise debtservicing from exposure to interest rate andinflation risk. In fact, what matters is not somuch the variability of debt servicing asthe volatility of corporate cashflows net of debt payments.
On the one hand, decreasing the share of fixed-rate bonds increases uncertainty aboutdebt servicing since interest payments onfloating-rate and inflation-linked bonds areuncertain. On the other hand, the increase inthe volatility of the promised repaymentmay lead to an increase in the correlationbetween changes in liability and asset valuesif the correlation of asset values and interestrates or inflation is positive.
In other words, issuing floating-rate orinflation-linked bonds may increase riskfrom the perspective of pure debtmanagement, but may decrease risk fromthe perspective of integrated asset/liabilitymanagement. From this trade-off emergesan optimal debt structure, and it can beshown that under (mild) simplifyingassumptions, minimising the volatility of
assets net of liabilities is equivalent tominimising the (risk-adjusted) probability of default, which is in turn equivalent tomaximising the value of the company.
Should corporates issueinflation-linked bonds?
10 THE TREASURER OCTOBER 2011
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OCTOBER 2011 THE TREASURER 11
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NUMERICAL ESTIMATES OF DEBTMANAGEMENT BENEFITS We therefore
find that the optimal share of floating-ratebonds increases with the correlationbetween changes in interest rates andchanges in the revenues of the company.When the correlation of a companysoperating cashflows (before interestexpenses) and interest rates is positive, itsfloating-rate debt should be made toaccount for a greater share of its total debtto avoid the high (bankruptcy) costsassociated with low cashflows and high debtservicing. When, on the other hand, thiscorrelation is negative, floating-rate debt
should account for a smaller share of totaldebt. Similarly, the optimal share of inflation-linked bonds increases when the correlationof changes in inflation rates and changes inthe revenues of the company rises.
On the whole, optimising the debtstructure leads to a smaller probability of default and so to a higher company value.One of our key conclusions is that debtmanagement decisions have a strongpositive impact on a companys value.Another is that, for reasonable parametervalues, companies should issue a non-zeroshare of inflation-linked bonds.
We also find that the opportunity costsassociated with failing to issue inflation-linked bonds are substantial. From animplementation perspective, derivativescould also be used to adjust interest rateand inflation risks, but derivatives would notbe the natural approach for long horizons inthe presence of counterparty risk.
RISK AND ASSET/LIABILITYMANAGEMENT FOR CORPORATES Fromthe normative standpoint (ie. theperspective of a company seeking tomaximise its value), the hedging motive isthe key determinant of debt managementdecisions given the relationship between thedebt structure that explicitly maximisescompany value and that which minimisesthe volatility of assets net of liabilities.Hence, the main benefit of optimising thedebt structure is to let companies reducethe variability of their net cashflows andtherefore lower the probability of default.
In other words, the main motive for debtmanagement is not to lower the cost of debt financing but to hedge exposure to
interest rate and inflation risks. In fact, bymatching the interest rate and inflationexposure of the liabilities to that of theassets, a company can lower the variability
of cashflows. This lowers the likelihood of default as well as the cost of debt and
increases equity value.To understand why specific risk factors in
asset returns matter, consider the optimalissuance of inflation-indexed bonds. Issuinginflation-indexed bonds reduces the cost of debt since the issuing party is sellinginsurance against inflation and receives theassociated premium. On the other hand,issuing inflation-indexed bonds rather thannominal bonds increases uncertainty infinancing costs because of the greateruncertainty in coupon payments. Thiscost/risk trade-off is the liability
management counterpart of the risk/returntrade-off in asset allocation.
Taking into account the assets of thecompany, however, changes matters.Because operating cashflows are oftenpositively related to changes in inflation,inflation hikes do not necessarily lead tofalls in net revenues for the issuer. In otherwords, issuing inflation-indexed bonds mayincrease risk from a liability perspective, butnot necessarily from an asset/liabilitymanagement perspective.
Inflation-indexed debt appears to haverisk-and-return properties superior to thoseof nominal debt, and the optimalcomposition of a debt portfolio will beaffected accordingly. In other words,intuition suggests that the optimal debtstructure should stem not solely fromminimising the cost of debt but also fromhedging the risks to a companys revenues.
THE FINDINGS Our understanding of liability management decisions barelyextends beyond the capital structure
decision (equity versus debt allocation), andwhen it addresses the debt structuredecision (fixed- versus floating-rate debtallocation) it relies mostly on qualitative
insight. Our research provides a jointquantitative analysis of capital structure
decisions and debt structure decisions in astandard continuous-time model in thepresence of interest rate and inflation risks.
Our main findings are that debtmanagement decisions affect capitalstructure decisions, and that substantialincreases in company value can be inducedby optimising debt structure. We also findthat a number of companies would benefitfrom issuing inflation-linked bonds.
Our analysis could be extended to includeother instruments, such as convertiblebonds, preferred shares and other equity-
linked structures in the liability mix.However, an explicit analysis of the optimalliability structure including such ingredientsmight prove technically challenging.
On a different note, our model considersthe liability allocation problem from thestandpoint of the original owners of thebusiness, who are assumed to be risk-neutralabout the (diversifiable) source of uncertainty impacting the value of theirbusiness. In practice, however, the managersof the company, unlike the owners, makethe corporate risk management and liabilityallocation decisions. Several papers havedocumented the role of conflicts of interestand managerial incentives in the design of corporate debt structure programmes(Smith and Stulz2, Stulz3, and Chava andPurnanandam4), and incorporating theseaspects would also be desirable.
Lionel Martellini is professor of finance atEDHEC Business School, and scientificdirector at EDHEC-Risk [email protected]
Vincent Milhau is senior research engineerat EDHEC-Risk [email protected]
Footnotes1 L Martellini and V Milhau (March 2011). Optimal Designof Corporate Market Debt Programmes in the Presence of Interest-Rate and Inflation Risks. Available for freedownload at www.edhec-risk.com2 C Smith and R Stulz (1985). The Determinants of FirmsHedging Policies, in Journal of Financial and QuantitativeAnalysis 20 (4), 391-405.3 R Stulz (1984). Optimal Hedging Policies, in Journal of
Financial and Quantitative Analysis 19 (2), 127-140.4 S Chava and A Purnanandam (2007). Determinants of the Floating-to-Fixed Rate Debt Structure of Firms, in Journal of Financial Economics 85 (3), 755-786.
THE OPTIMAL DEBTSTRUCTURE SHOULD
STEM NOT SOLELYFROM MINIMISING THE
COST OF DEBT BUTALSO FROM HEDGING
THE RISKS TO ACOMPANYS REVENUES.
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