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1-1-1998 Financing Publicly Traded U.S. Corporations in Public and Private Security Markets, 1970-1997: Where, How, How Much, With What, When and Why Kenneth A. Carow Purdue University

Gayle R. Erwin Purdue University

John J. McConnell Purdue University

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Carow, Kenneth A.; Erwin, Gayle R.; and McConnell, John J., "Financing Publicly Traded U.S. Corporations in Public and Private Security Markets, 1970-1997: Where, How, How Much, With What, When and Why" (1998). Purdue CIBER Working Papers. Paper 129. http://docs.lib.purdue.edu/ciberwp/129

This document has been made available through Purdue e-Pubs, a service of the Purdue University Libraries. Please contact [email protected] for additional information. Financing Publicly Traded U.S. Corporations in Public and Private Security Markets, 1970-1997: Where, How, How Much, With What, When, and Why

Kenneth A. Carow Purdue University

Gayle R. Erwin Purdue University

John J. McConnell Purdue University

98-001

Center for International Business Education and Research Purdue University Krannert Graduate School of Management 1310 Krannert Building West Lafayette, IN 47907~1310 Phone: (765) 494-4463 FAX, (765) 494-9658 Financing Publicly Traded U. S. Corporations in Public and Private Security Markets, 1970 p 1997:

Where, How, How Much, With What, When, and Why

by

Kenneth A. Carow, Gayle R. Erwin and John J. McConnell

An appropriate subtitle for this article might well be "The Evolution Lives! Long Live the Evolution!" Prior articles in this journal have described the forces that give rise to innovations in financial markets, have speculated on the endurance of the forces that propel financial innovation, and have documented the occurrence of certain innovations in financial security design. 1 In this article, we expand upon and update those articles with a focus on documenting the time series ofinnovations in the way in which publicly traded U.S. corporations finance themselves in public and private security markets. Our time series begins with 1970 and ends with 1997.'

Innovations have most definitely occurred in the types ofsecurities issued, and these have justifiably been the focus ofearlier articles in this journal. But innovations have also occurred in the way in which securities are issued and in the national locale in which the securities are issued. We document, by number and dollar amount, securities issued by U. S. corporations according to the method of issuance (traditional registered offerings, shelf registered offerings, private offerings, and Rule 144A private offerings), by the locale ofthe offerings (domestic U.S

I These include John Finnerty, (1992), "An Overview ofCorporate Securities Innovation," Journal ofApplied Corporate Finance, 4, 4, 25-39; Merton Miller, (1992) Financial Innovation: Achievements and Prospects", Journal ofApplied Corporate Finance; 4, 4, 4-11; and Peter Tufano, (1995), "Securities Innovations: A Historical and Functional Perspective", Journal ofApplied Corporate Finance, 4, 7, 90-103. 20ur data are obtained from Securities Data Corporation and include public and private offerings by U. S. companies whose common stock is publicly traded. offerings, simultaneous domestic and foreign market offerings, and foreign market offerings), and by the year of the offering. An earlier article in this journal identified iIU1ovations in the design of securities issued by U. S. corporations according to the year in which the design first appeared, ending in mid-1991.3 We supplement that article in two ways: (1) by updating developments in the design ofcorporate securities through the end of 1997 and (2) by presenting the annual time series of issues classified according to the design of the security from 1970 through 1997.

Our updating ofdevelopments in security design emphasizes that the pace of innovation in the design ofcorporate securities has not slackened. For example, Finnerty catalogues 40 new types ofsecurities that were first issued by U. S. corporations during the 1980s.4 We catalogue

31 new types of securities that were initially issued by publicly traded U. S. corporations during the first eight years of the 1990s. 5 These include such securities as equity indexed bonds, commodity indexed preferred stock, convertible exchangeable notes, and dividend enhanced convertible securities among others.

Our time series presentation also identifies which innovations have prospered over time and which have languished. For example, the first non-convertible (FRN) was issued in 1974. The use of FRNs increased nearly monotonically throughout the ensuing 24 years and during 1997, U. S. corporations issued 1,411 FRNs with an aggregate face value of

$139.8 billion. In comparison, the first convertible adjustable rate (CARE) came to market

] Finnerty (1992). 4 We exclude various types ofmortgage.backed securities and collateralized mortgage obligations because these more closely resemble asset sales than corporate fmancing. ~ Any classification system is subjective. For consistency, wherever possible, we adopt Finnerty's classification scheme. In some cases, that was not possible and in others, we detennined that a slightly modified classification structure better captured the flavor ofthe data.

2 in 1981. Ten additional CAREs were issued during the remainder of the 1980s, but none-have been issued since. These data illustrate that financial innovation is a trial and error process in which "failure is more likely than not".6

Corporate Financing in the Aggregate ~ • Where, How, and How Much

Publicly traded U. S. companies can Issue securities exclusively to U. S. investors, exclusively to non-U. S. investors or simultaneously to U. S. and foreign investors. Table 1 displays the number and dollar amount ofofferings according to the year and locale ofthe issue.

Pane] A is the time series ofpublic and private offerings in the U. S.; Panel B is the time series of public and private offerings made simultaneously in the U. S. and one or more foreign countries;

Panel C is a partial time series of offerings made in one or more foreign countries. Prior to describing the different types of securities issued, we focus on the data in Table I to provide an overview ofofferings in the aggregate by offering technique and locale.

U. S. Domestic Offerings

Within the U. S. market, securities can be issued in either the public or private market.

Any security that is registered with the S.E.C. is considered to be issued in the public security

market. Unregistered securities are considered to be issued in the private security market.

Prior to March of 1982, once a company had decided to issue a security in the public

market, the company prepared and filed with the S.E.C., a registration statement and prospectus

6 Tufano (1995).

3 describing the terms of the security and the dollar amount of funds to be raised. The company then waited for completion ofan S.E.C. review before issuing the security.

In March of 1982, the S.E.C. implemented Rule 415. Under Rule 415, public companies that meet certain size and credit requirements may register a generic statement with the S.E.C.

This generic registration statement (fonn S-3) includes the company's basic financial infonnation and the amount of securities the finn expects to issue within the next two years, although the life of the registration statement is indefinite. At the time the company decides to issue a specific security, the company is required to file a prospectus supplement that discloses the specific tenns and dollar amount of the security to be issued and incorporates by reference other financial infonnation filed by the company with the S.E.C.. Upon filing this information, the security can be issued. This procedure is popularly known as shelf registration because, in effect, the issuer puts its new securities "on the shelf' until the funds are actually needed. As shown in Panel A of Table 1, during 1983, shelf registered issues accounted for 20% of the number of securities offered and for 37% of the total dollar amount of funds raised in public offerings. In 1997, shelf registered offerings accounted for 49% of the securities issued and for

46% ofthe dollar amount offunds raised in the public market.

A similar transfonnation occurred in the private security market with the introduction of

Rule 144A in 1990. Securities issued in the private security market cannot be traded on an organized exchange. Furthermore, prior to Rule 144A, the original investor in an unregistered security could not trade the security in any venue for at least two years. Following that two-year period, the security could only be traded among "sophisticated" investors. Rule 144A allows unregistered securities to be traded among "sophisticated" investors immediately after issuance.

According to S.B.C. guidelines, a sophisticated investor is one who has the capacity to (1)

4 evaluate the risk and return characteristics ofthe security and (2) bear the financial risk contained in the security.

As shown in Panel A ofTable 1, during 1991, Rule 144A offerings accounted for 13% of the number ofprivate securities issued and for 19% of the total dollar amount offunds raised in private offerings. During 1997. Rule 144A offerings accounted for 64% of the securities issued privately and for 83% ofthe dollar amount offunds raised in the private market.

Simultaneous U. S. Domestic and Foreign Market Offerings

Panel B parallels Panel A in that offerings made simultaneously in the U. S. and one or more foreign countries are classified according to whether the offering is public or private and whether it is a shelf or 144A offering. This panel illustrates that simultaneous offerings have grown over time in both absolute number and dollar amount, but relative to the total of purely domestic offerings. simultaneous offerings still comprise a modest fraction. During 1997. the

$855 billion raised by U. S. corporations through purely domestic offerings was 18 times the $47 billion raised through simultaneous offerings. Additionally, this panel illustrates that the growth in shelfand 144A simultaneous offerings mirrors that ofPanel A.

u. S. Corporate Foreign Offerings

In Panel C, (beginning with 1983) offerings made outside the U. S. are classified'

according to whether they are denominated in U. S. dollars or a foreign currency. During 1997,

U. S. corporations raised $58 billion issuing 306 bonds outside the U. S. Ofthe total amount

issued. 54% were denominated in some currency other than U. S. dollars.

5 Types ofSecurities: With What, When, How Much, and Why

Traditional and Innovative

To introduce the array ofsecurities employed by corporate issuers, we classify them into

SIX generic categories and within those generic categories we classify the securities as

"traditional" and "innovative". The six generic categories are conunon stock, non-convertible , convertible debt, non-convertible preferred stock. convertible preferred stock and asset- backed securities. For our pUlJloses, a traditional non-convertible debt is any callable or noncallable non- or note with a fixed periodic cash payment, a fixed final date, and fixed repayment schedule. A traditional convertible debt is defined similarly except that the security is convertible into the conunon stock ofthe issuer at the option of the investor. Convertible and non-convertible bonds or notes with any other feature are categorized as irulOvative.

A traditional non-convertible preferred stock is any callable or noncallable non- convertible preferred stock with a fixed periodic cash dividend and no fixed maturity date. 7 A traditional convertible preferred stock is defined similarly except that the security is convertible into the conunon stock of the issuer at the option of the investor. Convertible and non- convertible preferred stock with any other feature are categorized as ilUlovative.

7 We do allow one'deviation from this defmition. Some preferred stocks do have modest sinking fund requirements. One example is a preferred with a fixed coupon rate and a sinking fund requirement of2% per year. Given the minimal requirements ofthe sinking fund, we classify this as a traditional preferred.

6 Asset-backed securities do not fit neatly into our classification scheme because of the absence of a "traditional" asset-backed security. Ergo, by definition, all asset-backed securities are innovative. Conversely, because, with few exceptions, common stocks are homogeneous in their characteristics, we classifY all common stocks as traditional. 8

The results ofour classification scheme are presented in Table 2. In 1970, of the 1,124 securities issued, one is classified as innovative. Over the period 1970 through 1975, 12 of6, 132 securities are identified as innovative. In 1985,317 of 2,405 (13%) securities are classified as innovative. During 1997, 2,644 of the 9,387 (28%) securities fall into the non-traditional category. Additionally, during 1997, $314.5 billion of the $902.3 billion (35%) in aggregate offerings were classified as innovative securities.

The fraction of securities classified as traditional and innovative securities varies across the six generic categories. As we noted, there are no innovative securities in the common stock category and there are no traditional securities in the asset-backed category. Within the other four categories, the fraction of offerings that are innovative falls between these extremes. For each year, among debt securities, traditional offerings outnumber innovative offerings in both number and dollar amount. For example, in 1997, the $456.2 billion of traditional non- convertible and convertible debt offerings was 2.2 times the $211.4 billion issued in innovative debt securities. In contrast, among preferred stocks, in some years traditional offerings exceeded innovative offerings and in some years the reverse was true. For example, in 1997, the $29.5 billion of traditional non-convertible and convertible preferred stock offerings was 1.1 times the

8 Finnerty (1992) documents several innovations in common stocks. Several common stock innovations failed prior to issuance; however, two innovations that were brought to market include puttable common stock and callable common stock. The combined offerings of these securities includes only 5 offerings raising $200 million in capital.

7 $25.9 billion issued in irulOvative preferred stock securities. In 1987, the $6.7 billion of

iIU10vative preferred stock was 1.2 times the $5.4 billions issued in traditional preferred stock

securities.

Innovative Features

An innovation in the design of a security occurs when one of the basic features of the

security is perturbed. According to our definition, a traditional debt security has a fixed periodic

pa)1l1ent in U.S. dollars, a fixed repa)1l1ent schedule payable in U.S. dollars, and a fixed maturity

date. -A perturbation in any of these features gives rise to an innovative security. For example,

when the fixed periodic pa)1l1ent is denominated in a foreign currency, a new security has been

created. Similarly, for preferred stock, any perturbation away from a fixed periodic dividend

payable in U.S. dollars or any perturbation away from a perpetual life gives rise to a new

security. For example, when the dividend payment is linked to commodity prices or when the

investor may shorten the life through a put feature, a new security has been created. In practice,

. most iIU10vative securities represent a combination of perturbations in the basic features of the

security. For example, a puttable floating rate bond perturbs the periodic pa)1l1ent and the

maturity date.

Presumably corporations issue these new securities to enable the issuer andlor investor to

accomplish something they could not achieve with existing securities or to replicate

opportunities currently available, but at a lower cost. Issuer induced iIU1ovations have been

designed to reduce agency and asymmetric information costs of raising capital, to reduce

financial distress costs, and/or to shift risks to market participants who are willing to bear them.

Investor induced innovations have been designed to increase liquidity, to reduce transactions

costs, and/or to shift risk. New securities may also be designed to meet the combined demands

8 of the issuer and the investor. For example, securities have been designed to reduce the

combined taxes of the issuer and the investors. Alternatively, innovations can be designed to

accomplish in a single transaction what might have previously required multiple transactions.

For example, a dual currency bond combines a and a long-dated forward contract

on foreign exchange.

Tables 3 through 6 present the number and dollar amounts of the different types of

innovative non-convertible debt (Table 3), convertible debt (Table 4), non-convertible preferred

stock (Table 5), and convertible preferred stock (Table 6). In each table the securities are

classified according to their specific features. Each security issued is represented only once.

That is, the categories are meant to be mutually exclusive. For example, Table 3 contains a

category titled floating rate notes (FRN). The table also contains a category labeled puttable

floating rate notes. Clearly a puttable floating rate note is a FRN. Nevertheless, because we

enter each security only once, a puttable floating rate note is not counted in the floating rate note

category. Thus, securities are classified as much according to features that they do not have as

well as features that they do embody.

Periodic payments

The most common perturbation to the periodic payment is linking the payment to an

index such as interest rates (e.g., floating rate notes, auction rate securities, and remarketed

securities) and foreign exchange rates (e.g., principal exchange rate securities and dual currency

bonds). For example, floating rate notes have coupon payments that equal a specific interest rate

index, such as LIBOR, plus a spread that reflects the risk of the issuer and the liquidity of the

security. Auction rate preferred stock and auction rate notes link the coupon or dividend

9 payments to the issuer's current market interest rate through a process of periodic auctions.

Remarketed preferred stock and remarketed notes use a remarketing agent to reset the coupon or dividend payments to the issuer's current market interest rate. Principal exchange rate securities have coupon payments that are linked to foreign currency exchange rates and are payable in U.S. dollars. Dual currency bonds have coupon and/or principal payments denominated in a currency other than U.S. dollars.

Interest rate and exchange rate linked securities can enable the investor and the issuer to match their asset and liability structures more closely so as to reduce the volatility of cash flows.

Reducing the volatility of cash flows may reduce taxes, financial distress costs, and/or agency costs. 9 Index linked securities like floating rate, auction rate, and remarketed securities reduce cash flow volatility by hedging interest rate risk. From the issuer's perspective, a non-puttable floating rate security can match cash inflows that decrease (increase) with interest rates with cash outflows that decrease (increase) with interest rates. Investors may have the opposite interest rate exposure. Similarly, exchange rate linked securities and dual currency bonds can provide a hedge for finns who are involved in international commerce. Despite their innovative nature, dual currency bonds have existing substitutes. For example, rather than issuing a dual currency bond, finns could issue in the foreign market. The more closely a substitute security mimics the payoffs of an ilU10vative security, the smaller the expected benefits -- net of transaction costs -- from the ilUlovation.

Auction rate securities, remarketed securities, and resettable securities also reduce infonnation costs by resetting interest rates to adjust for changes in the issuer's credit quality. As

9 Clifford Smith, Jr., Charles Smithson, and Sykes Wilford, Managing Financial Risk (Irwin Publishing, Burr Ridge, IL, 1995).

\0 the finn's credit rating deteriorates (improves), each of these securities increases (decreases) the finn's financing costs. This may reduce the fiffil'S incentive to increase the finn's future risk. 1O

Other perturbations of periodic payments include the exclusion ofany periodic payments

(e.g., zero coupon bonds), payments that increase or decrease over time in a predetennined schedule (e.g., step-up and step-down securities), payments in an asset other than cash (e.g., payment-in-kind securities), and payments linked to the credit quality of the issuer (e.g., credit sensitive securities). Specifically, zero coupon bonds, zero coupon convertible bonds, and liquid yield option notes (LYONs) have no payments until the maturity date; however, at maturity both the principal and accrued interest are due in a single payment. The coupon rate for step-up fixed rate notes increases by a specified amount at a stated future date. The spread above an interest rate index increases at a stated future date for step-up floating rate notes. The converse holds for step-down securities. Payment-in-kind notes and payment·in-kind preferred stock provide the issuer with the option ofmaking coupon or dividend payments in cash or in additional securities.

Credit sensitive bonds require an increase in coupon payments if the issuer's credit rating decreases.

Tax advantages also influence the decision to issue a new security. Prior to the passage of the Tax Equity and Fiscal Responsibility Act of 1982, the U.S. tax code allowed an issuer of zero coupon bonds to amortize the original discount on a straight line basis for tax purposes.

This feature allowed corporations to deduct interest for tax purposes at a rate faster than interest actually accrued on the debt. The 1982 Tax Act requires that corporations deduct interest as it .

10 However, we note that by increasing the issuer's interest payments when they can least afford it-that is, when cash flows are low-may increase fmancial distress costs.

11 actually accrues. Not coincidentallY, the number of zero coupon bonds issued subsequent to

1982 declined dramatically.

A relatively recent innovation is the tax-deductible preferred stock categorized in Table 5

as monthly income preferred stock and trust monthly income preferred stock.ll The innovation

with the tax deductible preferred has to do with the structure of the offering more than the

features ofthe security. In particular, with tax deductible preferred a parent company establishes

a trust that issues preferred stock. The proceeds from the preferred stock offering are used to buy

a bond issued by the parent company. The interest payments on the debt are deductible by the

issuer. With this structure. the parent receives the flexibility of preferred stock with the tax

deduction ofinterest payments on traditional debt.

Holding asymmetric infonnation costs and tax treatments constant, finns with greater

costs of financial distress can benefit from issuing obligations that do not require intennediate

cash payments, such as zero coupon bonds, preferred stock, or payment-in-kind securities. 12 By

not promising intennediate cash payments, issuers can reduce the near-tenn potential for

financial distress. The cessation of intennediate payments allows the possibility that the issuer

will be able to overcome its cash flow shortage prior to the maturity date. Of course, the

security's price will be more sensitive to the finn's credit rating. Payment-in-kind features

transfer additional risk from shareholders to bondholders, especially in an environment of

deteriorating credit risk or increasing interest rates. If rates increase. reducing the security's

market value, the issuer can (and will) make the interest payments in additional payment-in-kind •

II Arun Khanna and John McConnell, (1998), "MIPs, QUIPs, and TOPTs: Old Wine in New Bottles" Journal of Applied Corporate Finance, 11, 1,39-44. 11 Sankar De and Jayant Kale, (1993), "Contingent Payments and Debt Contracts," Financial Management, 22, 2, 106-122.

12 securities. The newly issued securities will have the same maturity and coupon payments as the existing payment-in-kind security. Even though the market value of the payment-in-kind securities is less than , the par value determines the number of additional securities necessary to meet the interest payments.

A step-up bond or a step-up preferred security perturbs the security's periodic payment, but its primary impact is on the expected maturity of the security. A step-up security increases the interest rate payment on fixed rate securities or the spread on floating rate securities. relative to the initial interest rate. Combining a step-up with the call feature provides the firm with the additional incentive to call the bond or preferred stock. In general. an issuing finn will call a security when current market rates are below the existing coupon rate. Since step-up securities increase the coupon rate, the likelihood that the security will be called is higher.

Tables 3 through 6 illustrate the ebbs and flows ofsecurities with features that perturb the periodic payments. The evidence indicates that some innovations have prospered. others have stagnated, and still others have dwindled away. To date, the most widely employed innovation has been the floating rate note. For instance, during the 1970s, a total of 20 floating rate notes were issued for a total of $2.9 billion in proceeds. Over the 1980s there were 706 floating rate notes issued for proceeds of $60.8 billion while during the first eight years of the 1990s there were 5,701 issues for a total of $573.2 billion in proceeds. No other iIUlOvative security compares to the volume and/or proceeds associated with floating rate notes.

In contrast, the use of zero coupon bonds. zero coupon convertible bonds and auction , remarketed notes has been steady but modest. For instance, with the exception of 1982 and

1997, the number of zero coupon bond issues has not exceeded 15 since they were introduced in

1981. The use of zero coupon convertible bonds and auction remarketed notes has never

13 exceeded 8 in any year. Finally, the use ofauction rate preferred stock, principal exchange rate

linked securities and convertible adjustable rate preferred stock has deteriorated over time.

Specifically, the number of auction rate preferred stock issues has ranged from 6 when first

introduced, to a peak of 107 issues in 1992, to 12 or fewer offerings during 1994 to 1997. The

use of principal exchange rate linked securities and convertible adjustable rate preferred stock

have never exceeded 7 issues in any year since their introduction and no issues have been made

during the last four years.

Repayment schedule and maturity dates

According to our definition, a traditional debt has a predetermined repayment schedule

payable in U.S. dollars and a fixed maturity date. Tradition~l preferred stock has perpetual life.

Any perturbations to these features give rise to an innovative debt security or preferred stock,

respectively. Perturbation to the repayment schedule includes securities that are exchangeable

into another security of the issuer (e.g. exchangeable preferred stock and mandatory convertible

securities), securities that are exchangeable into a security ofa company other than the issuer (i.e.

exchangeable ), commodity linked securities (e.g., commodity indexed p~eferred securities),

and stock index linked securities (e.g., Standard & Poor's 500 Index notes). For instance,

exchangeable preferred stock and convertible exchangeable preferred stock provide the issuer the

option to exchange the securities for a bond with similar characteristics. Mandatory convertible

preferred stock and mandatory convertible bonds require that the preferred stock holder exchange • the security for the issuer's common stock at the maturity date. Exchangeable debt allows the

investor to convert the security into the stock ofa third party, not the issuer. Commodity indexed

preferred securities pay a fixed dividend and have a principal value that is linked to the value ofa

14 commodity. Standard and Poor's 500 Index notes pay the principal amount plus accrued interest plus the excess (ifany) ofthe S&P 500 index value over the initial value ofthe index times some predetennined multiplier.

Exchangeable securities give the issuer the flexibility to time when to issue debt or preferred stock without the cost of refinancing. For issuers, preferred stock has a tax disadvantage relative to debt because interest expense is tax deductible while preferred dividends are not tax deductible. However, preferred stock has one important tax advantage for corporate investors -- only 30 percent of dividends received are treated as taxable income to the corporation. Part of the dividend-received deduction is passed through to the issuer by the willingness of corporate investors to accept a lower dividend rate. The disadvantage of non­ deductible dividends is small for a zero- or low·taxed corporation, providing a greater incentive to issue preferred stock. Should the issuer's marginal tax rate increase in the future, exchangeable preferred stock enables the issuer to replace the preferred stock with notes on which the interest payments are tax deductible. Alternatively, for issuers that currently have a high marginal tax rate and expect a reduction in the future, exchangeable notes provide the issuer the option to replace the note with preferred stock that has the same tenus and dividend payments as the note.

The conversion feature also impacts the security's maturity. The conversion feature can reduce the potential for moral hazards such as under-investment, asset-substitution, or leveraged

15 recapitalization. 13 The conversion feature provides bondholders with the assurance that they will participate in any increase in shareholder value that results from an increase in the firm's risk.

Furthermore, by lowering current interest rates, convertibles reduce the probability that cash constrained companies will be forced to forgo valuable investment opportunities. Thus, a well- designed convertible security is relatively immune to changes in risk because higher (lower) risk increases (decreases) the equity component and decreases (increases) the non-convertible bond component of convertible debt.

The benefits of mandatory convertible bonds (e.g., DECS) and mandatory convertible preferred stock (e.g., ACES) are similar to other convertible securities except that conversion into the common stock is required at maturity.14 DECs and ACES reduce the investor's downside protection, since the bondholder must convert into the common stock even if the conversion value is less than the bond's par value. Mandatory conversion implies a perpetual life for the security such that the security is usually treated as equity for balance sheet and regulatory purposes.

Perturbations to the maturity date include bonds that do not mature (e.g., perpetual floating rate notes), bonds that provide the investor with the option to sell the security back to the issuer (e.g., puttable bonds), and bonds with the option to extend the life of the security (e.g., extendible bonds). With perpetual floating rate notes, the security is infinitely-lived and the

II For a fmancially troubled fum, the under·investment problem arises when a larger portion ofthe returns from a new project must go to restore the value ofdebt securities before the shareholders receive any value. Asset substitution can occur when management can choose to invest in riskier projects after the debt is issued. Leveraged recapitalization can occur when management can reduce the value ofoutstanding bonds by increasing debt or adding debt senior to that in question. By increasing fum risk, both asset-substitution and leveraged recapitalization can transfer wealth from bondholders to stockholders. 14 In general, these securities pay a higher dividend than common stock and have limited potential for appreciation (either a cap on the price appreciation or a limit to a percentage ofthe price appreciation).

16 coupon payment is linked to an interest rate index. Puttable bonds and puttable convertible bonds include either a general put or a limited put. The general put provides the investor with the option to sell the security back to the issuer at a specific price and time prior to the security's maturity date. In contrast, the limited put may specify the conditions under which the security can be sold back to the issuer and/or the number ofsecurities that can be sold back to the issuer at a specified put date. Extendible bonds and extendible convertible bonds enable the holder to lengthen the life ofthe security.

Puttable bonds and extendible bonds provide investors with protection against declining interest rates and against the possible losses from deteriorating operating performance or a leveraged recapitalization. The put can be viewed as an option on the firm's creditworthiness as well as on interest rates. When interest rates increase or credit quality declines, bonds with a decline less than bonds without a put option. When the bond price falls below the put value (i.e., when interest rates rise), the investor can sell the bond back to the issuer at a fixed price. If the finn can meet the cash flow requirement, puttable bondholders are able to avoid further wealth reductions. If the finn is unable to meet the cash flow requirement, the finn is forced to restructure or declare bankruptcy. The downside protection for bondholders, provided by the put option, reduces the agency conflicts of asset-substitution or leveraged recapitalization.

Fundamentally, an is the same as a . A three-year fixed-rate bond with an extension feature for an additional three years is the same as a six-year puttable fixed­ rate bond with an option to exercise the put at the end of the third year. In either case, if the coupon rate on the bond does not exceed the current required return for a security with the same risk and features, investors will return the bond to the corporation at the end ofthe third year.

17 Liquid yield option notes (LYONs) combine many different features into a single security. For example, LYONs are puttable, callable, convertible, zero coupon securities. The put, call, and conversion feature each have an impact on the repayment schedule and the maturity date of LYONs. The zero coupon feature influences the periodic payments, while the put, call, and conversion feature influence the final maturity and final payment.

Among securities that perturb the repayment schedule and maturity dates, the use of puttable bonds has increased over the time series. During the 1970s corporations issued 16 puttable bonds to raise $0.8 billion. Over the 1980s there were 262 issues of puttable bonds for

$35.7 billion in proceeds. More recently, during 1990 to 1997,798 puttable bonds were issued for $140.3 billion. In contrast, the use of exchangeable preferred stock and mandatory convertible preferred stock has been modest, but steady over the time series (neither security type has exceeded 10 issues in any given year). However, the use of convertible exchangeable preferred stock and extendible bonds has waned over time. Over the 1980s, there were 123 issues ofconvertible exchangeable preferred stock for $9.6 billion in proceeds. During 1990 to

1997, 54 convertible exchangeable preferred stock were issued for $7.1 billion. During the

1980s, 243 extendible bonds were issued for $39.4 billion, while only 32 were issued during the

1990, for $4.8 billion.

Asset-backed securities

In Table 7, we present the number and dollar amounts of asset-backed securities classified by asset type. Asset-back securities create a secondary market that increases the security's liquidity. Intermediaries can purchase portfolios of assets, place them in trusts or special purpose corporations, and resell the securities through a process called securitization. For

18 corporations with a low credit rating, securitization may be able to reduce borrowing costs on that debt. The credit rating ofthe underlying pool ofsecurities is based on the underlying assets, not the issuer's credit quality. Thus, an issuer benefits from issuing a security with a credit rating that is superior to its own. As in any risk transfer, this advantage is not without costs. That is, since the remaining assets in the firm will be riskier, the existing bondholders and stockholders will be left with riskier assets. Whether the net cost of capital is reduced is unclear. The lower cost ofsecuritized debt may very well be offset by a higher cost ofequity and outstanding bonds.

The concept of asset-backed financing is relatively new in U.S. corporate financial markets. Asset-backed securities were introduced in 1985. Since that time, this market has grown from 7 issues to 646 issues in 1997 ($1.2 billion to $77.2 billion in proceeds, respectively). The types of assets used to back these securities have also increased over this period. For instance, in 1985 only automobile loans and equipment leases were securitized. By

1997, 19 categories of securitized assets existed. Three of these categories (credit card receivables, automobile loans, and revolving credit I home equity loans) dominate the asset­ backed market. In 1997, these three categories accounted for 469 out of the 646 (73%) asset~ backed securities that were issued. Additionally, during 1997, of the $77.2 billion raised in the asset-backed security market, $61.2 billion (79%) was classified in these three categories.

. Conclusion

This article examines the financing of publicly traded U.S. corporations in public and private security markets during 1970 through 1997. For each year, we document the number and

dollar amount of the method of issuance (traditional registered offerings, shelf registered

19 offerings, private offerings, and Rule l44A private offerings), the national locale of the offerings

(domestic, simultaneous domestic and foreign market offerings, and foreign market offerings), the types ofsecurities, and reasons for issuing these iIlllOvative securities. We document the use of over 76 innovative securities used by publicly traded U.S. corporations to raise over $1.7 trillion in capital. While traditional securities still dominate the market, the evidence indicates that the pace offinancial innovation noticeably increased during the 1980s and continues to grow during the 1990s. We also use our time-series to identify which innovations have prospered over time and which have languished. Finally, we identifY factors that have given rise to innovations and that may explain the growth or demise in certain types of innovations.

Kenneth A. Carow Gayle R. Erwin John J. McConnell is Assistant Professor ofFinance is Assistant Professor of Finance is Emanuel T. Weiler Professor of at the Kelley School ofBusiness, at the Mcintire School of Management and Finance Indiana University, Commerce, at the Krannert School of Management, University of Virginia. Purdue University

20 Table1 Number and Dollar Amounts ( in $ billions) of Security Issues by U.S. Corporations Classified by Method of Issuance

70 71 72 73 74 75 76 71 78 79 80 51 82 83 84 85 86 87 88 " 90 91 92 93 94 95 96 97 Panel A: U.S. Corporate Offerings in the U.S. Domestic Market

Public Offerln,_ Numberofl5sues 1125 1561 1692 566 492 708 669 525 547 554 1015 1140 926 1640 Proceeds ($ billions) 27.5 36,2 31.5 21.1 28.7 39,0 34.7 27,3

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Panel B: US Corporate Offerings Made Simultaneously in the US and In One or More Foreign Markets

Public Offerings (Excludes Number of Issue5 1 3 35 165 Proceeds ($ billions) 0,0 0.6 6,8 34,7

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Panel C: US Corporate Offerings In Foreign Markets (Excludes Simultaneous Offerings in US)

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•N Table 3 Number and Dollar Amount (in $ bi1fions) of Non-Convertible Debt Securities Issued by US Corporations Classified by Features Security Name I Description 70-75 76 77 78 79 80 81 81 ~ ~ M ~ 87 "M ~ 91 91 93 .. " 96 97 Internt Rate Linked Securilles:

Puttable Floating Rate Bonds: Coupon rate noats with an interest rate index. Bonds are pultable at the option of the investor. No. issued 1 1 Proceeds 0.3 0.1

Step-Up I Step-DoWTl Floating Rate Notes: FRN whose spread over an interest rate index increases or decreases at a future date. No. issued 642 30 67 88 23 44 31 Proceeds 1.0 1.7 0.6 7.3 8.8 8,9 1.0 2.0 2.2

Fixed I Floating Rate Bonds: Coupon rate is fixed during the bonds early life and noats thereaOer. No. issucd 1 8 4 9 3 Proceeds 0.4 0,3 0.2 04 0.6

Yield Curve Notes I Maximum Rate Noles I Power Notes: Coupon rate equals a specified rate less an interest rate index. No issued 2 1 2 5 Proceeds 04 0.0 0.1 03 Table 3 - Continued Number and Dollar Amount (in $ billions) of Non-Convertible Debt Securities Issued by US Corporations Classified by Features Security Name I Description 70-75 76 77 78 79 80 81 81 ~ ~ ~ ~ ~ g " ~ 91 ~ ~ 94 " 96 97 Payments Linked to Other Assets:

Rate Sensitive Securities: coupon rate increases (decreases) if the issuer's credit rating deteriorates (improves). No. issued 2 4 Proceeds 0.2 1.1

Principal Exchange Rate linked Securities (PERLS) and Reverse PERLS, Principal and/or coupon payments are payable in US dollars, but payments are linked to the exchange rate. No, issued 6 4 7 7 I l l Proceeds 0.5 OJ 0.4 0.5 0.1 0.2 02

,,~

Fixed Rate Securities:

Puttable Bonds and Poison Put Bonds: Bond is redeemable at a pre-specified price at the holder's option. No. issued 2234524 8 , 26 6 32 28 41 110 l8 35 96 165 106 86 126 146 Proceeds 0.0 0.2 0,0 0.3 0.3 0.0 0.3 0.1 01 2.3 0.3 2.7 3.3 6.3 20.3 6.4 66 13.7 27.3 16.7 17,4 24.5 27.7

Step-Up / Step_Down Fixed Rate Notes: Coupon rate is adjusted up or down al a predelennined point in Ihe future. Nn. issued , 9 2 I Proceeds 1.3 1.8 0.0 00 Table 3· Continued Number and Dollar Amount (in $ billions) of Non·Convertible Debt Securities Issued by US Corporations Classified by Features Security Name I Description 70·75 76 77 78 79 80 81 " 8J 84 85 .. 87 88 .. 90 " 92 " 94 " .. 97 Payment-In-Kind Noles: Notes on which the interest payments can be made in cash or additional noles, al the option oflhe issuer. No. issued 4 , 1 2 1 1 Proceeds 0.7 11 00 03 02 0.0

Other Debt Innovations: Depositary : Debenlures issued using depository TCceipts. No. issued 4 1 2 2 1 2 4 1 1 OJ 0.2 0.0 0.1 05 OJ 0.5 0.0 00 Table 4 Number and Dollar Amount ( in $ billions) of Convertible Debt Issued by US Corporations Classified by Feature

Securlly Name I Descriplion 70-75 76 77 78 79 80 81 82 VM" ~ 87 U" ~ 91 92 93 94 95 96 97

Inlerest Rate Linked Securities:

Adjustable Rate Convertible Debt: Coupon interest varies directly with the dividend rale on the underlying common stock. No issued I Proceeds 02 Fixed Rate Securities:

Puttable Convertible Bonds: Convertible bond that can be redeemed prior to maturity, althe option of the holder. No. issued 2 I 6 3 7 4 2 2 5 5 Proceeds 00 0.1 0.4 0.1 0.4 0.1 0.7 0.2 0.2 0.9

Zero Coupon Convertible Debt: Non-interest bearing convertible debt issucs. No. issued 5 I 1 1 4 5 2 2 I II Proceeds 0.2 0.0 0.1 0.4 1.0 0.8 0.2 0.5 0.1 0.1 0.4

Convertible Exchangeable Notes: Convertible bond that allows the issuer to substitute convertible preferred shares with an identical yield. No, issued I I I I Proceeds 00 00 0.1 0.1

Step-Up Income Redeemable Equity Noles No_issued 2 J Proceeds 0.2 0.5 Table 4 - Continued Number and Dollar Amount (in $ billions) of Convertible Debt Issued by US Corporations Classified by Feature

Sl'<:urity Name I Description 70.75 H 77 ~ ~ h 81 81 ~ ~ ~ H n ~ M ~ 91 91 ~ ~ ~ % n

Dividend Enhanced Convertible Securities (DECS): Debt that must be converted at a specified dale. Generally pays a cash dividend above that on the underlying common stock and has capped share value. No. issued I I I l l J Proceeds 00 0.8 0.2 0.4 0.5 05 Table 5 Number and Dollar Amount (in $ billions) of Non-Convertible Preferred Stock Issued by US Corporations Classified by Feature

Security Name I Description 70-75 76 77 78 79 80 81 ~ ~ ~ ~ ~ n ~ M ~ 91 92 93 94 9S 96 97

Intereset Rate Linked Securities:

Variable Tenn Floating Rate Preferred Slm:k No. issued 6 2 \8 4 Proceeds 0.3 0.8 L2 0.2

Rcmarkeled Preferred Stock Dividend rate is reset every period by a remarketing agent. No. issued \ \ 14 25 9 6 , 5 13 I Proceeds 0.0 0\ 0.9 20 0.' 03 0.2 0.3 0' 0.1

Step-Up f Step-Down Preferred Stock: An adjustable preferred stock security who's dividend spread over an index increases or decreases. No. issued I 2 I 4 Proceeds 0.0 0.1 0.2 4.3 Payments Linked to Other Assets:

Indexed Sinking Funds Preferred: The amount of each sinking fund payment is indexed to a specified interest rate index. No. issued I I I I 2 I I 3 I Proceeds 01 0.1 0.0 0.1 01 0.0 01 01 0.6

Exchangeable Preferred Stock: Preferred stock exchangeablc into the debt with similar characteristics at the option of the issuer. No_ issued II 2 2 4 6 3 I 4 I 2 3 10 Proceeds 06 01 02 L2 0.' 0.3 03 02 02 0.' 0' 18 L7 Table 5 - Continued Number and Dollar Amount of Non-Convertible Preferred Stock Issued by US Corporations Classified by Feature

Security NRme I Dl'Sctlption 70-15 M n ~ ft ~ 81 82 ~ ~ ~ H ~ ~ ~ ~ 91 ~ " ~ ~ %"

Trust Monthly Income Preferred Stock (Toprs, Trups, Hytops): A version of Mips issued by a trust. No. issued 8 44 60 Proceeds 1.3 11.1 6.0 Table 6 Number and Dollar Amount (in $ billions) of Convertible Preferred Stock Issued by US Corporations Classified by Feature

Security Name I Description 70-75 76 77 78 79 80 81 n ~ ~ ~ ~ ~ g " ~ 91 ~ ~ 94 ~ % 9'

Interest Rate Linked Securities:

Convertible Auclion Rate Preferred: Convertible preferred slrn:k with dividend payments set via an auclion. No. issued ) Proceeds 02 Fixed Rate Securities:

Convertible Exchangeable Preferred Stock (CEPS): Convertible preferred that is exchangeable, at the issuer's oplion, for convertible debt wilh similar rale and conversion terms. No. issued 1 14 6 22 38 21 8 13 4 8 6 17 3 2 5 9 Proceeds 0.1 1.0 0,2 1.8 3.2 2.2 0.5 0.6 09 0.3 0.6 1.7 0.1 0.3 14 18

Depositary Convertible Preferred: Convertible prererred stock issued using depository receipts. No. issued 3 1 1 3 7 7 1 2 Proceeds 0.2 OJ 0.6 2.1 2.1 1.2 0.2 0.1 Table 6 - Continued Number and Dollar Amount ( in $ billions) of Convertible Preferred Stock Issued by US Corporations Classified by Feature Security Name I Descripllon 70-75 76 " " 79 "" " " 84 " 86 "" " " 91 92 93 """ " Mandatory Conversion:

Mandatory Conver1ible Preferred Stock (PERCS): Preferred stock that must be conver1ed at a specified date. Generally pays a cash dividend above that on the underlying common stock and has capped share value. No. issued II III 6 5 4 2 6 7 J Proceeds 00 0.0 0.0 03 0.0 2.7 3.1 0.4 0.0 0.7 09 0.2

Automatically Convertible Equity Shares (ACES): similar in structure to DECs. Preferred stock coupled with a contract obligating the holder to buy a future stock issue. No. issued 2 3 I 2 Proceeds 0.4 05 0.1 02 Table 7 Numberand DollarAmount( in $ billions)of Asset~BackedSecuritiesIssued by US Corporations Classified by Asset Type

Security Name I Description 85 86 87 88 89 90 91 92 93 94 95 96 97

I 2 I I 5 4 2 9 0.2 OJ 0.1 1.0 0.4 0.2 02 1.0 '(fi'--e' i'O emer1tl:1)aiJsJt~-;:;:Jj\iJ~i'J'NO-(ii~u«ffj~~~j~~\f';:;';;;Pa~",'~~g";w;'i!]~~~~~'T>~'~~'1ii.'%l~,~-~iliI ,,'., "~,,'J :}@'} *i~\';¥tJ'::"~;~1~,i-,,_*,,":,:~,{,;,~;>'·r,%"¥.'~~-;;~%~i~.~:tflt,~~~~fiN!j{,\C~~j~i;'•-'i!?~:t~W:~,~if1j'O{:>"'f!I~~,;11fl:~'i'i,{, .'.~~ iii _.~I,~AA'~,@~w¥ri'¥,J"<:','~~'r:,:~H'r~~s;f~!;j;:11!'~"@:-;~";':~:":~;'~1,~~,-~;(~""tr-M(Wrj:i~t'1""cJ~,,~,('tt~~ll".. r;'''}i;~V:-j.t~r.{hA:,,,~ InstallmentReceivables No, issued Proceeds