Reactions to the EDHEC Study - Faculty and Research

More documents

Recommendations

Info

Reactions to the EDHEC Study “Optimal Design of Corporate Market Debt Programmes in the Presence of Interest-Rate and Inflation Risks” - May 20122. Background and Methodology1 - Each of these methodshas unique risks anddrawbacks, and there isgenerally a trade-off betweenaccuracy and cost. Forexample, inflation swaps(ignoring counterparty risk)are a direct hedge, however,they may be prohibitivelycostly. TIPS similarly havelow returns. Ang et al. (2011)have studied the relationshipbetween specific stocks andinflation, while others havefound that, generally, equitiesare negatively correlated withinflation in the short-term,but positively correlatedover longer horizons. Thus,equities, as well as real estateand commodities have beenidentified as inflation hedges,albeit imperfect ones (see e.g.Amenc et al. 2009).2 - For example, in March2012, US TIPS were sold withrecord negative yields (seee.g. Eddings 2012).3 - Strong investor demandfor inflation-linked corporatebonds is reflected in the“sell-out” of Tesco’s recentlyissued (Dec. 2011) inflationlinkedbond offering (seeHyde 2011).4 - See e.g. Inderst (2010)who finds that infrastructurecompanies, as well as utilities(which sometimes haveregulated price increases tiedto inflation indices) haveinflation-linked cash flows.5 - As mentioned, utility andinfrastructure companieshave been known to haverevenues strongly correlatedto inflation, while, forexample, others have noted anegative correlation betweeninflation and the revenuesof banking companies(which hold high amounts offinancial assets; see Boydet al. 2001).2.1. Background: The case forinflation-linked corporate bondsInflation risk has been a growing concernfor all investors while for some, suchas pension funds which have liabilitiesdirectly tied to an inflation index, inflationhedging has always been of criticalimportance. The assets used by investorsto hedge inflation risk typically includesovereign inflation-linked bonds, such asU.S. Treasury Inflation Protected Securities(TIPS), inflation swaps, equities, andcommodities. 1 Sovereign bonds tied to aninflation index, however, have lost some oftheir appeal to investors. In particular, thelow returns of these bonds 2 coupled withrising uncertainty of sovereign issuers’credit-worthiness have contributed toan environment where inflation-linkedbonds issued by corporations may emergeas an appropriate substitute for sovereigninflation-linked bonds. 3Many institutional investors, while theyoften have fixed liabilities, are free tochoose in terms of defining their assetallocation. Conversely, the assets ofcorporations which issue bonds forfinancing are relatively fixed, whilethey have the opportunity to adjusttheir liabilities through various formsof debt-issuances, including inflationlinkedbonds which are typically tied toan inflation index such as the CPI, andfloating rate bonds which are tied tothe evolving level of interest rates. Firmswith high correlation between their cashflows and inflation can effectively hedgethe inflation risk inherent in their cashflows by issuing inflation-linked debt. Forexample, it is often argued that firms inthe utility sector 4 have revenues whichincrease with inflation, thus offeringnatural compensation for an obligationto pay inflation-linked coupons on bondsissued. This same type of debt can beused by investors to hedge inflationbasedliabilities. Furthermore, corporatebonds share a credit risk component withcorporate liabilities (particularly pensionliabilities), making them a more naturalliability hedge than sovereign bonds(Scherer 2006). Thus inflation-linkedcorporate bonds potentially provide ameans to reduce the risk of certain issuerswhile simultaneously reducing the risk ofinvestors.Despite the fact that levels of correlationof corporate cash flows with inflationvary widely across companies, 5 corporatedebt issuances are nearly uniform in theirtreatment of inflation risk – with most ofthem refraining from issuing inflationlinkeddebt. As a consequence, the marketfor inflation-linked corporate debt is notwell developed. For the UK, Leaviss (2010)estimates the outstanding amount ofinflation-linked corporate debt at $11billion, compared to a total market of$342 billion for corporate bonds. Anotherillustration of the scarcity of inflationlinkedcorporate bonds is that amongstthe 94 corporate bonds available from theretail bonds outlet of the London StockExchange, there are only two inflationlinkedbonds.The lack of development of the corporateinflation-linked debt market in practice,has a parallel in the academic literaturewhich has relatively little to say on howto optimally choose – as an issuer –between different types of debt (e.g.inflation-linked versus nominal debt). Theacademic literature on debt-management8 An EDHEC-Risk Institute Publication
Reactions to the EDHEC Study “Optimal Design of Corporate Market Debt Programmes in the Presence of Interest-Rate and Inflation Risks” - May 20122. Background and Methodology6 - Leland (1994), Lelandand Toft (1996) and Ju andOu-Yang (2006) all examinedcapital structure theoryassuming fixed-rate debt.7 - For some extremeparameter values we foundthat an optimal level requireda negative position (whichcould be obtained throughderivative-based tools).and capital structure has studied theidea of an “optimal” capital structure (i.e.the decision of how to split the firm’ssources of financing between equity anddebt), however, these models of optimalcapital structure typically assume fixedratebonds, 6 and thus ignore the possiblechoices among different types of debt.In particular, such a narrow focus ondebt-versus-equity financing ignoresthe impact of hedgeable risk factorsoriginating from firm assets and how theycould be mitigated through an optimaluse of different types of debt.A recent EDHEC-Risk Institute paper titled“Optimal Design of Corporate MarketDebt Programmes in the Presence ofInterest-Rate and Inflation Risks” hasexamined optimal debt structures ofcorporate issuers who have the optionto issue different types of debt. Ratherthan focusing solely on the decision touse debt-versus-equity for financing,the paper studies the optimal choiceamong different types of debt, lookingat floating-rate and inflation-linkedbonds in particular. The study considershow such elements of the debt structurewould help to hedge inflation and interestrate risks that are present on the assetside. As a premise, the paper assumed thatthe objective pursued by optimising debtstructure is to maximise firm value, asopposed to decreasing the average cost ofdebt servicing or to make it less volatile. Aprominent finding was that hedging therisk factors that impact the asset (evenpartially), led to lower variability of cashflows, net of debt costs, thus decreasingthe chance of default and consequentlymaximising firm value. Moreover, theleverage ratio that is attained with anoptimal mix of fixed-rate debt, floatingrateand possibly inflation-indexed bondsis shown to be higher than that attainedwith nominal bonds only. In other words,optimising debt structure enables thefirm to take on more debt, which showsthat optimal capital structure depends onthe chosen debt structure.The study clearly shows that thecorrelation between asset values andinterest rates, and the correlationbetween asset values and inflation, willinfluence the optimal mix of fixed-ratedebt, floating-rate debt and inflationlinkeddebt. 7 In particular, higher levels ofcorrelation of asset value with inflationshould incite the issuer to offer lessfixed-rate debt and more inflation-linkeddebt. Different levels of correlation alsoproduced different levels of increases tofirm value, with higher absolute values ofcorrelation resulting in a larger increase,and higher positive correlation resultingin the largest increase, as depicted in thefollowing table taken from the study.Table 1. Depicts the benefit of adopting an optimal debtstructure which includes inflation-linked bonds across firmswith different levels of correlation between firm risk andinflation riskCorrelation between firm's riskand inflation riskRelative increase in firm valuefrom optimising debt structure-0.5 0 0.515.2% 10.8% 45.4%Proper interpretation of these resultsrequires analysing firm risk within thecontext of firm-wide cash flows andfirm-wide uncertainty. Traditional debtmanagement strategy has establishedthe clear goal of liability minimisation.Employing such a narrow focus on thecost of debt has led to the standardconclusion that variable rate bonds areAn EDHEC-Risk Institute Publication9
Page 1: An EDHEC-Risk Institute Publication
Page 10: Reactions to the EDHEC Study “Opt
Page 13: 3. Survey ResultsAn EDHEC-Risk Inst
Page 17 and 18: Reactions to the EDHEC Study “Opt
Page 21 and 22: 4. ConclusionAn EDHEC-Risk Institut
Page 23 and 24: ReferencesAn EDHEC-Risk Institute P
Page 27 and 28: About Rothschild & CieAn EDHEC-Risk
Page 29 and 30: About EDHEC-Risk InstituteAn EDHEC-
Page 33 and 34: EDHEC-Risk InstitutePublications an
Page 40: For more information, please contac

Reactions to the EDHEC Study - Faculty and Research

Create successful ePaper yourself

Delete template?

Save as template?