Financial Institutions Center Callable Bonds and Hedging by Levent Güntay N.R. Prabhala Haluk Unal 02-13 The Wharton Financial Institutions Center The Wharton Financial Institutions Center provides a multi-disciplinary research approach to the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest. Franklin Allen Richard J. Herring Co-Director Co-Director The Working Paper Series is made possible by a generous grant from the Alfred P. Sloan Foundation Callable Bonds and Hedging Lev ent Güntay R. H. Smith Sc hool of Business University of Maryland College Park, MD 20742 (301) 345-1174 lguntay @ r h smith .umd.edu N. R. Prabhala R. H. Smith Sc hool of Business University of Maryland College Park, MD 20742 (301) 405 2165 nprabhal@ rh smith.umd.edu Haluk Unal ∗ R. H. Smith Sch ool of Business Univ ersity of Maryland College Park, MD 20742 (301) 405 2265 hunal@rhsmith.umd.ed u First Version: Augu st 2000 This Ve rsion: February 2002 Keywor ds: Hedging; Risk Management; Callable Bonds. JEL Cla ssiÞcations: G3 0; G32. ∗ Corresp onding author. We thank many of our colleagues, and especially to Yiorgos Allayannis and Catherine Schrand for extensive comments on an earlier draft. Ca lla b le B o n d s an d H e d g in g Abstract We provide evidence that Þrms attach call options to debt issues to manage interest rate risk. We show, using extensive time series data on these hedging transactions, that the hedging decision is explained remarkably well by theories of hedging demand, such as the bankruptcy and underinvestment explanations for why Þrms hedge. Our setting also leads to new and unique evidence on the importance of the supply side in determining Þrms’ hedging strategies. Consistent with this idea, we document that Þrst time issuers in bond markets and small Þrms are more likely to hedge using call options in bonds, contrary to virtually all received evidence that large Þ rms are more likely to hedge. The role of the supply side in hedging is further underlined by our evidence of a secular and robust shift away from calls in the 1990s, a period of rapid growth and increased a vailability of OTC derivatives. Every Þrm that issues Þxed rate debt must decide whether to attach a call option to the debt issue. The call option gives the issuer the right to call the bond at a Þxed strike price any time before bond maturity, after an initial “protection” period. The option helps issuers hedge against declining interest rates, by allowing them to call the bond if interest rates drop and replace it with lower-cost debt. While some issuers a ttach call options to their debt issues, others do not . In this paper, we examine the determinants of this choice between callable and non-callable debt over a long time s eries of debt issues between 1981 and 1997, using an extensive set of explanatory variables that includes Þrm characte ristics, issue characteristics, and market conditions. Our analysis contributes to two strands of literature. First, we add to the early empirical liter- ature on why Þrms attach call options to their bond issues (Thatcher (1985), Mitchell (1991), Kish and Livingston (1992), Crabbe and Helwege (1994)). Our evidence consolidates the fragmented results reported in this literature, and provides Þndings consistent with a hedging explanation for attaching call options to bonds. The hedging explanation Þnds surprisingly weak support in previous studies, which report that interest rates are often weakly signiÞcant, insigniÞcant, or even negatively related to call usage. In contrast, we show that call usage is positively and signiÞcantly related to multiple proxies for the incremental in terest rate risk from debt issues, such as issue size, maturity and the level of interest rates. These results resolve an empirical puzzle recently reported by Crabbe a nd Helwege (1994) that none of the received securit y design theories - un- derinvestment, overinvestment, and signaling (Barnea, Haugen, and Senbet ( 1980), Robbins and Schatzberg (1986), Schwartz and Venezia (1994)) - explain why Þrms issue callable bonds. Our evidence suggests that risk management concerns of Þrms explain the callable/non-callab le bond choice. As Kraus (1983) writes, the interest-rate hedging explanation for issuing callable debt “has received little, if any, attention in the Þnance literature, [but] it offers another clue to the 1 puzzle - one that gets closest to management’s concern about the need to protect the company against exposure to changes in interest rates.” Our evidence pro vides this missing link. Having established the risk management motivation for using callable bonds, we empirically characterize the determinants of this hedging decision. Our analysis introduces, for the Þrst time, extensive time series evidence to the risk management literature. We begin by examining the role of the demand side in hedging. On the demand side, w e document a rich array of Þrm c h aracteristics explains the decision to hedge via callable bonds. Proxies for bankruptcy risk are positively related to call usage, supporting bankruptcy cost based theories of hedging. Proxies for Þrms’ growth opportunities such as the book-to-ma rket ratio are also positively related to the call usage, consistent with an underinvestment rationale for hedging. On-balance sheet Þnancial liabilities that substitute for hedges or add to hedging demand are also signiÞcantly correlated with the decision to attach call options to debt issues. These results are particularly striking because of their strength relative to previous studies, and their remarkable consistency with theories of hedging demand. In addition to the evidence on theories of hedging demand, we develop unique evidence on the importance of the supply side in determining Þrms’ hedging choices. The arguments of Litzen- berger (1992) and Nance, Smith, and Smithson (1993), formally modeled in Mozumdar (2001), suggest that supply side barriers relating to informational and transaction cost scale economies can have a Þrst-order effect on hedging strategies of Þrms. We report sev e ral Þndings that are consistent with this role for the supply side. The Þrst Þnding relates to Þrm size. With one notable exception - the analysis of the reinsurance industry by Mayers and Smith (1982) - the risk management literature empirically Þnds that large Þrms are more likely to hedge. This is puzzling because hedging demand theories imply that smaller Þrms should be more likely to hedge. We 2 provide evidence that reconciles this empirical puzzle. Consistent with the negative size-hedging relation in reinsurance noted by Mayers and S mith, we also Þnd that Þrm size is negatively re- lated to the usage of callable bonds. Thu s, when supply side impediments to derivatives usage are absent, as in callable bonds, small Þrms are indeed more likely to hedge. Second, we document a secular and robust shift away from callable bonds in the 1990s. While over 80% of debt issues in the 1980s we re callable, less than 50% of issues in the 1990s attached call provisions to debt issues. The shift away from call usage in the 1990s is signiÞcant even after controlling for the lower interest rates in this decade, and a range of economy-wide, issue- speciÞc, and Þrm-speciÞc variables. Supply-side arguments plausibly explain why Þrms shifted away from calls in the 1990s. This decade has witnessed rapid growth and increased availability of OTC derivatives marke t. Because these derivative products became increasingly accessible to more Þrms in the 1990s, Þrms should Þnd less need to manage interest rate risk by bundling a call option with debt issues in the 1990s. Our Þndings are consistent with this hypothesis. Differences in behavior between Þrst-time and repeat issuers in the bond market are also consistent with the supply-side barriers argument. Such barriers to OTC derivatives usage are probably more signiÞcant for debutant e issuers entering the ÞxedincomemarketfortheÞrst time, and if so, Þrst time issuers should be more likely to hedge using callable debt. We document the existence of such a positive relation between the use of callable debt and Þrst time issuers of bonds. Finally, we provide additional evidence on the role of the supply side by analyzing the switching behavior of issuers that moved away from callable bonds in the 1990s. If the shift is explained by the increased accessibility and availability of OTC derivatives in the 1990s, Þrms with more access to OTC derivatives should be more lik ely to switch away from callable to non- callable bonds in the 1990s. We Þnd evidence consistent with this implication. Our cross-sectional 3 evidence collectively suggests that informational and scale barriers to O TC derivatives usage have a Þrst-order inßuence on the hedging strategies of the Þrm, as suggested in Litzenberger (1992) and Mozumdar (2001). Our results are robust to re-speciÞcation of the baseline probit model distinguishing between callable/non-callable issuers. We estimate a speciÞcation that controls for endogeneity in the choice of debt maturity. We also estimate a sequential probit model that allows for the possibility that Þrms attach a call option only when the incremental interest rate risk created by a debt issue is material. The sequential model effectively compares callable bond issuers to a subset of non-callable issuers, Þrms that face signiÞcant incremental exposure but still choose not to issue callable bonds. Our main results remain r obust to these and other speciÞcation changes. Our Þndings offer some of the Þrst insights into time-series properties of hedging at the level of individual transactions by the Þrm. Thus, we complement the approaches used in previous hedging studies, which include analysis of responses to questionnaires sent to CEOs/CF Os (Nance, Smith, and Smithson, 1992), case studies involving speciÞc Þrms (Chacko, Tufano, and Verter, 2001; Chidambaran, Fernando, and Spindt, 2001), studies of particular industries (Mayers and Smith, 1993; Tufano, 1996; Schrand and Unal, 1998), or studies that examine the aggregate, Þrm-wide portfolio of derivatives (G´eczy, Minton, and Schrand, 1997; Allayannis and Weston, 2000). In addition, these results offer, for the Þrst time, extensive time series evidenc e on hedging. Gathering time-series evidence is important because annual disclosures in Þnancial statements, the dominant source of data for previous hedging studies, became mandatory only in 1990. Thus, there exists little evidence on hedging behavior in the 1980s. Evidence from the 1980s is also importantbecausesigniÞcan t growt h in the OTC derivatives markets has occurred mainly in the1990s. Little is understood about hedging strategies before and after the explosive growth in 4 the OTC markets. Our study Þllsinthisvoid. The rest of the paper is organized as follows. Section 2 describes the data used in the study. Section 3 reports the main estimates of a multivariate probit speciÞcation to explain the decision to attach call options to bond issues. Section 4 reports estimates of additional speciÞcations, including a sequential probit model, a triangular system in which maturity is an endogenous variable, and data on switching from callable to non-callable bonds. Section 5 offers conclusions. I. Data To identify our sample Þrms, we start with the New Issues database of Securities Data Company (SDC) and identify non-convertible Þxed rate bonds issued between January 1981 and December 1997. We include in our sample bond issues completed only by nonÞnancial Þrms and selected service Þrms. To exclude issues made by Þnancial Þrms, we omit Þrms with 4-digit SIC codes between 6000 and 6999. We further screen out 146 Þrms in the Þltered sample with names that contain the phrases “Acquisition,” “Capital,” “Credit,” “Financial,” “Finance,” “Funding,” “Leasing,” and “Security.” We also exclude leasing Þrms (SIC codes equal to 7352, 7353, 7359, 7377, 7513, and 7515). In addition, service Þrms in the educational services, social services sectors, membership organizations, and other non-classiÞable establishments (SIC codes between 8200 and 8299, 8300 and 8399, 8600 and 8699, and 9000-9999) are excluded from the sam p le. We obtain 7943 bonds as a result of these t wo Þlters. Additionally, we restrict our sample to Þrms for which cross-sectional information is available in the COMPUSTAT database. The COMPUSTAT and SDC matched sample consists of 4188 bond issues from 1981 to 1997. To classify a bond as callable or non-callable is not as straightforward as it may seem. The 5 call provision in a bond consists of a call protection period, after which bonds can be called at the issuer’s option, typically up to the Þnal maturity of a bond. In some instances, while the bond can be identiÞed in the database as callable, the call protection period could be sufficiently close to the maturity of the bond, in which case the bond should be treated as non-callable. Thus, we examine the call protection period and the maturity of a bond before identifying a bond issue as callable. We use the SDC database data Þeld “number of years until maturity” to identify the maturity of the bond and where this Þeld is missing, we calculate it using the “issue date” and “Þnal maturity date” Þelds. With regard to bond maturity structures, it is well known that most corporate bond issues have standard at-issue maturity structures such as 3, 5, 7, 10, or 30 y ears, in line with the maturity structures of the most liquid on-the-run treasuries off which the bonds are priced. We Þnd a similar, though not identical, distribution for call periods. When the call protection period and the maturity structures are compared, we observe that, for 5 year bonds, the average call protection period is 3 years or lower, while the average call protection period is close to 5 ye ars for all longer maturity callable bonds, consistently across all maturity structures and the sample period. Hence, we deÞne a bond as being callable if the call protection period is less than one year for bonds with 3-7 year maturity, 5 years for bonds with 7 to 10 year maturity, 7 years for bonds with 10 to 15 year maturity, and 10 years for bonds with greater than 15 year maturity. Figure 1 reports the percentage of bonds in our sample that are callable for each year between 1981 and 1997, while Table I gives related statistics for the full sample period as well as the two subperiods from 1981 to 1988 and 1989 to 1997. Clearly, callable bonds are the debt instruments of choice in the 1980s. Ho wever, there is a structural shift away from calls beginning in about 1989 when the proportion of callable issues starts to tail off. For instance, callable bonds constitute 6 [...]... interest rate risk management is an important consideration in choosing between callable and non -callable bonds, and this relation does not manifest industry-speciÞc effects Having established the hedging motive for the callable/ non -callable bond issue, we now intro11 duce variables that inßuence the demand for or supply of hedging into the probit speciÞcation The probit model is a reduced form speciÞcation... Jr., and Charles W Smithson, 1993, On the Determinants of Corporate Hedging, Journal of Finance 48, 26 7-2 84 Robins, Edward H., and John D Schatzberg, 1986, Callable Bonds: A Risk-reducing Signaling Mechanism, Journal of Finance 41, 93 5-9 49 Sarkar, Sudipto, 2001, Probability of Call and Likelihood of the Call Feature in a Corporate Bond, Journal of Banking and Finance 25, 50 5-5 33 Schrand, Catherine, and. .. Market, Journal of Business 63, 1 9-4 0 Mitchell, Karlyn, 1991, The Call, Sinking Fund, and Term-To-Maturity Features of Corporate Bonds: An Empirical Investigation, Journal of Financial and Quantitative Analysis 26, 20 1-2 21 Mozumdar, Abon, 2001, Corporate Hedging and Speculative Incentives: Implications for Swap Market Default Risk, forthcoming in the Journal of Financial and Quantitative Analysis Nance,... on a Bond, Journal of Finance 33, 118 7-1 200 Booth, James R., Smith, Richard L and Richard W Stolz, 1984, Use of Interest Rate Futures by Financial Institutions, Journal of Bank Research, 15, 1 5-2 0 Crabbe, Leland E., and Jean Helwege, 1994, Alternative Tests of Agency Theories of Callable Corporate Bonds, Financial Management 23, 3-2 0 Chacko, George, Peter Tufano and Geoffrey Verter, 2001, Cephalon Inc... variable is predicted to be greater or lower for issuers of callable (C) issuers versus non -callable (N C) bond issuers Table II reports the median and mean value of each characteristic for the whole sample, for issuers of callable bonds (C Þrms) and non -callable bond issuers (NC Þrms) and the Wilcoxon z(p) values for testing differences between C and N C Þrms If a characteristic is a binary variable, such... Review 76, 32 3-3 29 Kidwell David S., 1976, The Inclusion and Exercise of Call Provisions by State and Local Governments, Journal of Money, Credit and Banking 8, 39 1-3 98 Kish, Richard J and Miles Livingson, 1992, Determinants of the Call Option on Corporate Bonds, Journal of Banking and Finance 16, 68 7-7 03 Kraus, Alan, 1983, An Analysis of Call Provisions and the Corporate Refunding Decision, Midland Corporate... the transition year from a call usage to a non-call usage regime We classify Þrms as non-issuers, callable issuers, or non -callable issuers We deÞne a callable issuer as a Þrm that makes callable issues amounting to at least 70% of its total debt issues during the designated period Likewise, non -callable Þrms should have at least 70% of issues as non -callable Others are classiÞed as mixed issuers... fact that the few transportation Þrms that did use callable bonds in the Þrst subperiod switched to non -callable bonds, making the probit model inestimable with a transportation dummy In speciÞcation (1) in Table VIII, size is signiÞcant at 5%, and has a positive sign Thus, 26 larger Þrms are more likely to switch out of callable bonds to non -callable bonds In speciÞcation (2), we replace Þrm size by... Corporate Finance (Basil Blackwell, LTD, England) Smith, Clifford W., and Ren´ Stulz, 1985, The Determinants of Firms’ Hedging Policies, Journal e of Financial and Quantitative Analysis 20, 39 1-4 05 Smith,Clifford, Jr, and Warner Jerold B., 1979, On Financial Contracting: An Analysis of Bond Covenants, Journal of Financial Economics 7, 11 7-1 61 Stohs, Mark H., and David C Mauer, 1994, The Determinants of... signiÞcant at a p-value of better than 1% for the full period and the second subperiod, and has 5% signiÞcance for the Þrst subperiod This suggests that growth Þrms are more likely to issue bonds with attached call options, while low-growth Þrms choose the non -callable alternative This positive correlation between growth opportunities and issuing callable debt is consistent with two arguments Bodie and Taggart . Financial Institutions Center Callable Bonds and Hedging by Levent Güntay N.R. Prabhala Haluk Unal 0 2-1 3 The Wharton Financial Institutions Center The. between callable and non -callable bonds, and this relation does not manifest industry-speciÞceffects. Having established the hedging motive for the callable/ non-callable