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Differential market reaction to Eurobond financing
DIFFERENTIAL MARKET REACTION TO EUROBOND FINANCING Michael G. Ferri Timothy F. Sugrue Jot Yau
I. INTRODUCTION As Folks and Aggarwal[5] point out, the Eurobond market has been an important source of financing for U.S. firms since 1974. Three reasons seem to account for this development. The first is that net yields on Eurobonds are widely believed to be less than those on comparable, domestically issued debt. (See Finnerty and Nunn [4] and Kidwell, Marr, and Thompson [6].) The second reason for the appeal of Eurobond financing is that issuing firms do not have to disclose as much information in the Eurobond market as in the U.S. market. Firms do not have to register with the SEC, the bonds are not listed, and getting a credit rating for the debt is optional in many cases. The final reason why many U.S. firms have issued Eurobonds is that their covenants are far less restrictive than those of domestically placed debt. Kim and Stulz [7] believe that this fact reflects the complex legal situation involving enforcement of contracts, while Deshpande and Philippatos [2] expect that the investors’ desire for anonymity and bearer bonds (which Eurobonds are) restrains their impulses to challenge the manager’s decisions. Because of these benefits, the market’s reaction to the news of a Eurobond offering should be more favorable than its response to similar information on straight domestic debt. The latter response is small and insignificant, according to research by Dann and Mikkelson [l], Mikkelson and Partch [8], and Eckbo [3]. In fact, the interesting recent studies by Kim and Stulz and Deshpande and Philippatos (hereafter, KS and DI’, respectively) show that market reaction to announcements about straight Eurobonds is generally positive and statistically meaningful. Moreover, each study finds that a majority of the individual responses are positive. However, a large number of responses, amounting to 40% or more of all observations were negative. If Eurobond financing is advantageous, this fact needs to be explained. Michael G. Ferri, Timothy F. Sugrue, and Jot Yau sity, Fairfax, VA 22030 Global Finance Journal, ISSN: 10440283
2(1/2), l-10
Department of Finance, George Mason UniverCopyright 0 1991 by JAI Press, Inc. All rights of reproduction in any form reserved.
2
GLOBAL FINANCE JOURNAL
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The first goal of the current research is to identify the attributes of the bonds or the issuing firms which determine the size and sign of the responses by the market. For this reason, the paper analyzes stock price reaction to announcements of a carefully selected sample of non-convertible Eurobond issues and tests plausibIe determinants of those responses. This paper also extends existing research by examining market responses to the issuance of a substantial number of Eurobonds sold after June, 1984. At that time, the U.S. withholding tax on new domestic bonds was repealed, with the probable result that foreign investors became more interested in domestic U.S. bonds. Other reasons make 1984 an important date: the U.S. dollar weakened considerabIy after that, and firms which had had only limited access to the Eurobond market were able to float debt there. Hence, an investigation of these later bonds can add new information to the literature which has, until now, focused on the market’s development up to 1985. The paper is organized as follows. Section II discusses data and sample criteria. Section III presents the methodology. Section IV provides an account of the testing and its results. A summary and conclusions appear in Section V.
II. DATA AND SAMPLE SELECTION The sample of announcements of Eurobond issues, in the period from 1978 to 1987, was gathered according to these criteria. First, each announcement of issuance or intent to issue is directly linked with the sale of a specific bond. Second, each bond is a non-convertible, fixed-rate instrument with no warrants attached. Third, the firm’s stock is traded on the American or New York Stock Exchange, and its returns are available on the CRSP Daily Return File. Fourth, each bond is regularly monitored by Moody’s Bond Survey, which is the main source of information about the key characte~stics of the bonds. Fifth, the announcement of issuance or intent to issue is recorded on an identifiable day in the Wall Street Journal, The New York Times, or the Financial Times. Almost 85% of the announcements appeared in the WSJ; and, in the few cases of more than one announcement, the earliest one functions as the day of announcement for this paper’s tests. It should be noted that, in the late 1970s and early 198Os, publications such as E~~o~o~~ sometimes carried news of a firm’s plan to offer a Eurobond months into the future. Only one bond in the current sample, which largely consists of bonds issued after 1984, received such advanced publicity. Sixth, no other firm-specific information, such as the sale of a domestic bond or news on earnings, which might affect share price, appears on the date of announcement or the previous date. Two additional criteria cause the current sample to differ rather sharply from those of DP and KS, and any comparison of the studies’ results will have to recognize the difference. The seventh criterion is that the debt is guaranteed by the parent of an issuing subsidiary or is a direct obligation of the firm. This requirement prevents problems which may derive from the uncertain legal status of unguaranteed subsidiary debt (KS, p. 192). Though excluding many bonds
3
Differential Market Reaction to Eurobond Financing
from the 197Os, this rule ensures that the market does perceive the bonds to be obligations of firms whose share prices are used to record the impact of the issuance. The eighth and final requirement for an announcement to be included is this: the issuing firm did not offer another Eurobond in the prior six months, which is the time used for the estimation of the market model’s parameters. This criterion, which excludes a number of bonds from the mid-1980s, reflects the findings of DP and KS that a Eurobond announcement may shift returns away from the pre-existing market model. If the sample were to contain firms with several issues in a short time, this paper’s test of determinants could suffer from inaccurate parameter estimates and biased values for the abnormal returns around announcements. In short, this rule ensures more reliable results for the test of determinants of the market’s reaction. The cumulative impact of all the rules produces a sample which is not as large as those found in previous empirical studies. The initial collection of Eurobond issues and announcements contained over 200 observations. As the various rules were applied, the sample size fell. The rules which excluded most bonds were those requiring guarantees, no previous issues, monitoring by Moody’s, and identified announcement days. Descriptive statistics for the sample appear in Table 1. Some key features of the sample are these. The total number of issues is 47. The number of issuing firms is 41, since some firms sold more than one bond over the 10 years. Many types of
KEY FEATURES
Table 1 OF SAMPLE
OF EUROBONDS
Year
Number of bonds by year
Average maturity in years
Minimum/ maximum maturity
Median equity value
Median Moody’s rating
Type of issuer: I,U,Fa
1978 1979 1980 1982 1983 1984 1985 1986 1987
1 1 1 5 2 2 16 16 3
12.0 15.0 8.0 7.6 9.0 8.5 8.9 12.1’ 7.7
-
$3723b 5068 368 3672 4000 2800 4165 8344 3222
A Caa A/Baa A A/Baa A A A
Bat*)
0,0/l LO,0 LO,0 2,112 Ll,O TO,0
“1, U, and F stand for Industrial,
718 B/10 7110 5116 5130’ 3/10
10,5,1 12,2,2 2,0/l
Utility, and Financial Bonds, respectively. bMarket value of firms’ equity, in millions of dollars. In 1983 and 1984, the averages are reported. CExcludes a perpetuity. (*) The median of the yearly group’s “typical Moody’s rating” as compiled from COMPUSTAT and Moody’s sources.
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issuers are represented: 31 bonds were issued by industrial firms; the rest are almost evenly divided between bonds of public utilities and debt of financial firms (such as banks, holding companies, and insurance firms). In the sample, average maturity is near 10 years, though numerous bonds have maturities of 57 years. Most (37) of the bonds were issued after June, 1984. Over the time of the sample, the typical issuer’s market value of equity has fluctuated but shown no trend up or down. The same situation applies to the reputational capital of the firms: as data from COMPUSTAT and Moody’s show, the typical bonds rating generally stayed near “A.”
III. METHODOLOGY The methodology follows the standard approach to event studies (see Mikkelson and Partch [S], in particular). Daily abnormal, risk-adjusted returns are calculated as the difference between a stocks actual return and the return described by the single-index market model. The model’s parameters are estimated for the period running from day t = -180 to day t = -61, where the day of announcement is day t = 0. The index used throughout the statistical analysis is the CRSP Equally Weighted Index. The tests described below examine price changes over two key days: The day an announcement appears in print and the day before. Hypotheses about the cumulative average standardized abnormal returns for the two-day period of (-1,O) use the Z-statistic from Mikkelson and Partch and Kim and Stulz [7].
IV. TEST RESULTS A. Estimated
Market
Reaction
The tests focus on and try to explain the stock market’s reaction to the announcement over two days (-1,O). As KS argue, day t = -1 needs to be included because information about the upcoming sale could be available in London on that day. Table 2 contains the two-day average abnormal returns for the entire sample and selected subsamples. For each average, there is the Z-statistic for a test of difference from zero and the percentage of market responses that are positive. The first element in the table is the negative mean return (- .52%) for the entire sample, and the relatively small percentage (41%) of positive responses among the 47 observations. The Z-statistic is significant only at the 10% level, but it suggests that the typical reaction to a Eurobond announcement tends to be negative. This result differs from those of both KS and DP who find mainly positive market responses and a significantly positive mean excess return of approximately .5%. The difference probably reflects the times of the various samples. DP worked with issues offered up to 1984, and most of KS’s offerings occurred before 1985. Most of the current sample appeared after June, 1984, and
5
Differential Market Reaction to Eurobond Financing
Table 2 AVERAGE ABNORMAL STOCK RETURNS AROUND ANNOUNCEMENTS OF EUROBOND OFFERINGS (DAYS-1,O) FOR FULL SAMPLE AND SELECTED SUBSAMPLES Subsample Full sample Issued after 1984 In currency of dollar In other currency Callable bonds Non-callable bonds Industrial bonds Non-industrial bonds
Returns (%)
Z-Statistic
% Positive
hJ
-.52 -.29 -.81
-1.46b -0.95 -2.09”
41 43 36
47 37 33
.17 -.32 -.73
0.53 -0.16 -1.93”
57 49 35
14 24 23
-1.10 .07
-2.37” 0.32
50 57
24 23
“Significant at 5% level in 2-tailed test of the hypothesis dardized abnormal return equals zero. bSignificant at 10% level in similar test.
that the average stan-
the next row’s test of post-1984 issues detects no meaningful market reaction. When KS examine those issues in their sample that were sold after mid-1984, their results are very similar to those given here. Three other results in Table 2 deserve notice. Announcements of dollar bonds produce a significant mean return of -.81% with a high percentage of negative responses, while non-dollar bonds generate a positive but insignificant return (and Z-value). Notice of callable bonds produces a very small Z-value and more positive than negative reactions, while announcements of non-callable debt have a significantly negative mean return of -.73%. Finally, announced offers of industrial bonds generate a significant mean abnormal return of - l.lO%, while non-industrial bonds produce negligible reactions. The next part of this paper reports the results of general regression tests of the influence of these and other key variables.
B. Determinants
of Reaction
In the manner of KS, this paper tries to find the influences on the size and sign of the reaction to an announcement. The approach is to identify a set of plausible independent variables and to regress the two-day abnormal returns against them. Following the work of DP and KS, the chosen independent variables should reflect key features of the issuing firm and its debt instrument, an impor-
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tant element in the market at the time of the issuance of the bond, and the typical unexplained variability of non-systematic risk of the stock’s return. A description of each variable and an explanation of its expected sign follow. Indusfrial This binary variable takes on the value of zero if the issuing firm is a bank, a public utility, or a financial service company, and takes the value of unity otherwise. The work of DP first raised the prospect of a differential market reaction to regulated and non-regulated issuers, and the earlier test of means showed that the market does react differently to the two groups of bonds. However, another explanation (from Parente and Alcamo [9]) relies on the greater ability of nonindustrial firms to engage in financial engineering and more flexible financial policies during the mid-1980s when mergers and acquisitions threatened the credit quality of so many industrial firms. For either reason, the coefficient of INDUSTRIAL should be negative. Denomination This binary variable has the value of unity if the issue is denominated in dollars and a value of zero if it is denominated in yen, marks, Swiss francs, or other currency. Again, DP encouraged this line of analysis, suggesting that a non-dollar bond was more risky and hence might evoke a negative response to its issuance. Their argument was that the firm’s exposure to currency fluctuations on paying interest and principal creates the risk. It is also possible, however, that bonds denominated in non-dollar currencies probably hedge existing exposure in revenues for these multi-national firms, and that what risk there is reflects the relative volatility of the major international currencies. According to this thesis, the coefficient for this variable will be negative, signifying that the dollar’s value has been more volatile in recent years than that of most major currencies. Callabilify Whatever the causes for call provisions on corporate bonds (and a debate on that matter has been in progress for some time), there is no doubt that shareholders are pleased for the flexibility that callability provides. Hence, it is likely that the market’s response to a Eurobond offering will be more favorable and positive if that bond is callable than if it is not. As a result, CALLABILITY, a binary variable which equals 1 if the bond is callable, should have a positive coefficient. Issueprice This variable is the bonds price, as a percentage of par, as its issuance. The value of ISSUEPRICE ranges from 99% (for a discount bond) to 101% (for a premium bond). The reason for including ISSUEPRICE is that it provides some information on the state of the Eurobond market near or at the time of issuance. If the level of demand is low, the bond may sell at a discount and not produce net savings to the issuer. If demand were high, the bond’s issue price would be
Diferential Market Reaction to Eurobond Financing
7
at or above par, and this would signal benefits to issuing Eurobonds rather than domestic debt. The market’s reaction to an announcement should incorporate its awareness of the state of the Eurobond market. (It is important to note that issue day is close enough to announcement day across our sample to justify using price as an index of market sentiment at the time of announcement.) So, ISSUEPRICE should take on a positive sign in the regression; the lower (higher) the price of the issuing bond, the smaller (higher) is the market’s reaction to news of the issuance. Firmsize This control variable is defined as the natural log of the market value of the firm’s equity. Stickel [lo] proposes its inclusion as one way of counteracting possible nonconstant variance of the abnormal returns. Such variance could create cross sectional dependence of the error terms and bias the regression results. Because investors would expect large firms to exploit their access to the Euromarket, the abnormal returns around announcements are not likely to be positively associated with the size of the issuing firm. Hence, FIRMSIZE should have a negative coefficient. Non-Systematic Risk As Stickel [lo] and Mikkelson and Partch [8] point out, regression-based explanations of the prediction error around an announcement require the explicit inclusion of a measure of a firm’s typical level of unexplained variability. Only in this way can the regressions account for the different variances across firms and avoid the problem of heteroscedasticity. This variable is labeled NONSYS and is defined as the standard deviation, over the estimation period, of the residuals of the market model. It is evident that these tests do not include some variables which might be considered important to a bonds value and hence to the market reaction to its issuance. For example, maturity is omitted. In fact, some tests which contained maturity were conducted for this study; they found, as did KS, that maturity is irrelevant to the market’s response. For these reasons, maturity is not an independent variable in the test reported here. Also, the testing does not incorporate a variable for pre- and post-1984. The sample just has too few pre-1984 bonds to support a thorough test of this complex question. Further, the size of the issue is not included among the explanatory variables. One reason is that the various data sources failed to give consistent figures for the amounts of debt involved in many offerings. Often, the key financial newspapers and Moody’s sharply disagreed about the size of a bond offering. Also, most of these issues (however their sizes were gauged) were quite small compared to their firms’ total leverage. This fact, and the findings by KS that issue size is not pertinent, argue that omitting size poses no specification problem. In functional form, then, this paper’s approach to explaining the two-day abnormal returns around the event is given by this equation: ARi = KINDUSTRIAL,, DENOMINATION,, CALLABILITY, ISSUEPRICE, FIRMSIZE, NONSYSi)
(1)
GLOBAL FINANCEJOURNAL 2(1/2),1991
8
fori= 1,. . . , 48 bonds in the sample. The work of Stickel [lo] and Mikkelson and Partch [S] suggest that an equivalent but more suitable specification for estimation is this: AR*i = f(INDUSTRIALi/NONSYS, DENOMINATIONi/NONSYS, CALLABILITYi/NONSYSi, ISSUEPRICEi/NONSYSi, FIRMSIZEiINONSYSi)
(2)
where AR’, equals (ARi/NONSYSi) and is the standardized abnormal two-day return around the event. Table 3 reports on the regression results for equation (2); in that table, the original names of the variables are retained for the sake of convenience and clarity. Table 3 shows that the fit between the standardized abnormal returns and the explanatory variables is encouragingly close. The specification explains 13% of the cross-sectional variation in standardized abnormal returns, and the F-value is reasonably high. This situation represents an improvement over the results of KS and indicates that more comprehensive sets of independent variables can account for some of the wide variation in stock price reactions to Eurobond announcements. The independent variables performed in an interesting way. As expected, classification as an industrial or non-industrial company (INDUSTRIAL) is important to the size of the abnormal stock returns. The negative reaction to indusTable 3 REGRESSION RESULTS FOR TESTING DETERMINANTS OF THE MARKET’S REACTION TO EUROBOND ANNOUNCEMENTS Dependent Variable = Standardized Abnormal Return over days (-1,O) around a Eurobond announcement N = 47 Bonds Independent variablea Constant INDUSTRIAL DENOMINATION CALLABILITY ISSUEPRICE FIRMSIZE
Adjusted R2 = .13
F = 2.36~
Coefficient
t-Statistic
-0.515 -0.015 -0.016 0.014 0.022 -0.002
-1.062 -2.114b -1.995b 2.089& 1.093 -1.311’
aAl independent variables have been adjusted by being divided by NONSY&. See text for more detail bSignificant at the 5% level in a one-tail test of difference from zero according to expected relationship. CSignificant at 10% level in a similar test.
Differential Market Reaction to EurobondFinancing
9
trial bond sales is not easy to explain, but it does appear that stockholders showed some concern about the identity of the issuers. The denomination of the bonds payments (DENOMINATION) figures prominently in the market’s reaction to the announced offering, with dollardenomination leading to more of a negative response than non-dollar currencies, Such a relationship conforms to the view that the market sees the nondollar issues as covering exposure on the revenue side. The performance of ISSUEPRICE is somewhat disappointing: its coefficient is positive, as expected, On the other hand, the coefficient of but not statistically significant. CALLABILITY is also positive, as predicted, and significant. The market does care if a bond issue is callable. FIRMSIZE has the expected negative coefficient, but it is not different from zero at a significance level above 10%. Perhaps, the large sizes of most issuing firms prevent this variable from playing a meaningful role in this regression.
IV. SUMMARY The test finds a negative but insignificant reaction by the stock market to issues of non-convertible Eurobonds, most of which were announced and sold after 1984. This result differs from some earlier studies, which concentrate on pre-1984 issues. The difference in the timing and tax codes probably explains the diverging results. Further, the analysis revealed that the market response to the announcement depends on the type of issuing firm, the denomination of the bonds currency, and its call provisions.
REFERENCES “Convertible Debt Issuance, Capital [l] Dann, L.Y., and W.H. Mikkelson, Structure Change, and Financing-Related Information.” Journul of Finunciul Economics, 13:157-186 (June 1984). [2] Deshpande, S.D., and G.C. Philippatos, “Leverage Decisions and the Effect of Corporate Eurobond Offerings,” Journal of Applied Economics 20:901-915 (1988). [3] Eckbo, B. E., “Information Asymmetries and Valuation Effects of Corporate Debt Offerings,” JournaZ of Financial Econurnics, 15:119-151 (January/February 1986). [4] Finnerty, J.E., and K.R. Nunn, “The Determinants of Yield Spreads on US and Eurobonds,” Management hterrzationul Review, 25123-33 (Spring 1985). [5] Folks, W.R., Jr., and R. Aggarwal, International Dimensions of Financial Management, PWS-Kent: Boston, MA (1988). [6] Kidwell, D.S., M.W. Marr, and G.R. Thompson, “Eurodollar Bonds: Alternative Financing for U.S. Companies,” Finamid Management, 14:18-27 (Winter 1985). [7] Kim, Y.C., and R.M. Stulz. “The Eurobond Market and Corporate Financial
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GLOBAL FINANCE JOURNAL
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Policy: A Test of the Clientele Hypothesis,” lournal ofFinancial Economics, 22: 189-205 (December 1988). [S] Mikkelson, W.H., and M. Partch, “Valuation Effects of Security Offerings and the Issuance Process,” Journnl of Financial Economics, 15: 31-60 (January/February 1986). [9] G.M. Parente and B. Alcamo, Anafomy of the Eurodohr Straight Bond Market, 1987, Bond Market Research, Salomon Brothers, Inc. (May 1987). [lo] Stickel, S.E., “The Effect of Value Line Investment Survey Rank Changes on Common Stock Prices,” Journal of Financial Economics, 14: 245-274 (March 1985).
I. INTRODUCTION As Folks and Aggarwal[5] point out, the Eurobond market has been an important source of financing for U.S. firms since 1974. Three reasons seem to account for this development. The first is that net yields on Eurobonds are widely believed to be less than those on comparable, domestically issued debt. (See Finnerty and Nunn [4] and Kidwell, Marr, and Thompson [6].) The second reason for the appeal of Eurobond financing is that issuing firms do not have to disclose as much information in the Eurobond market as in the U.S. market. Firms do not have to register with the SEC, the bonds are not listed, and getting a credit rating for the debt is optional in many cases. The final reason why many U.S. firms have issued Eurobonds is that their covenants are far less restrictive than those of domestically placed debt. Kim and Stulz [7] believe that this fact reflects the complex legal situation involving enforcement of contracts, while Deshpande and Philippatos [2] expect that the investors’ desire for anonymity and bearer bonds (which Eurobonds are) restrains their impulses to challenge the manager’s decisions. Because of these benefits, the market’s reaction to the news of a Eurobond offering should be more favorable than its response to similar information on straight domestic debt. The latter response is small and insignificant, according to research by Dann and Mikkelson [l], Mikkelson and Partch [8], and Eckbo [3]. In fact, the interesting recent studies by Kim and Stulz and Deshpande and Philippatos (hereafter, KS and DI’, respectively) show that market reaction to announcements about straight Eurobonds is generally positive and statistically meaningful. Moreover, each study finds that a majority of the individual responses are positive. However, a large number of responses, amounting to 40% or more of all observations were negative. If Eurobond financing is advantageous, this fact needs to be explained. Michael G. Ferri, Timothy F. Sugrue, and Jot Yau sity, Fairfax, VA 22030 Global Finance Journal, ISSN: 10440283
2(1/2), l-10
Department of Finance, George Mason UniverCopyright 0 1991 by JAI Press, Inc. All rights of reproduction in any form reserved.
2
GLOBAL FINANCE JOURNAL
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The first goal of the current research is to identify the attributes of the bonds or the issuing firms which determine the size and sign of the responses by the market. For this reason, the paper analyzes stock price reaction to announcements of a carefully selected sample of non-convertible Eurobond issues and tests plausibIe determinants of those responses. This paper also extends existing research by examining market responses to the issuance of a substantial number of Eurobonds sold after June, 1984. At that time, the U.S. withholding tax on new domestic bonds was repealed, with the probable result that foreign investors became more interested in domestic U.S. bonds. Other reasons make 1984 an important date: the U.S. dollar weakened considerabIy after that, and firms which had had only limited access to the Eurobond market were able to float debt there. Hence, an investigation of these later bonds can add new information to the literature which has, until now, focused on the market’s development up to 1985. The paper is organized as follows. Section II discusses data and sample criteria. Section III presents the methodology. Section IV provides an account of the testing and its results. A summary and conclusions appear in Section V.
II. DATA AND SAMPLE SELECTION The sample of announcements of Eurobond issues, in the period from 1978 to 1987, was gathered according to these criteria. First, each announcement of issuance or intent to issue is directly linked with the sale of a specific bond. Second, each bond is a non-convertible, fixed-rate instrument with no warrants attached. Third, the firm’s stock is traded on the American or New York Stock Exchange, and its returns are available on the CRSP Daily Return File. Fourth, each bond is regularly monitored by Moody’s Bond Survey, which is the main source of information about the key characte~stics of the bonds. Fifth, the announcement of issuance or intent to issue is recorded on an identifiable day in the Wall Street Journal, The New York Times, or the Financial Times. Almost 85% of the announcements appeared in the WSJ; and, in the few cases of more than one announcement, the earliest one functions as the day of announcement for this paper’s tests. It should be noted that, in the late 1970s and early 198Os, publications such as E~~o~o~~ sometimes carried news of a firm’s plan to offer a Eurobond months into the future. Only one bond in the current sample, which largely consists of bonds issued after 1984, received such advanced publicity. Sixth, no other firm-specific information, such as the sale of a domestic bond or news on earnings, which might affect share price, appears on the date of announcement or the previous date. Two additional criteria cause the current sample to differ rather sharply from those of DP and KS, and any comparison of the studies’ results will have to recognize the difference. The seventh criterion is that the debt is guaranteed by the parent of an issuing subsidiary or is a direct obligation of the firm. This requirement prevents problems which may derive from the uncertain legal status of unguaranteed subsidiary debt (KS, p. 192). Though excluding many bonds
3
Differential Market Reaction to Eurobond Financing
from the 197Os, this rule ensures that the market does perceive the bonds to be obligations of firms whose share prices are used to record the impact of the issuance. The eighth and final requirement for an announcement to be included is this: the issuing firm did not offer another Eurobond in the prior six months, which is the time used for the estimation of the market model’s parameters. This criterion, which excludes a number of bonds from the mid-1980s, reflects the findings of DP and KS that a Eurobond announcement may shift returns away from the pre-existing market model. If the sample were to contain firms with several issues in a short time, this paper’s test of determinants could suffer from inaccurate parameter estimates and biased values for the abnormal returns around announcements. In short, this rule ensures more reliable results for the test of determinants of the market’s reaction. The cumulative impact of all the rules produces a sample which is not as large as those found in previous empirical studies. The initial collection of Eurobond issues and announcements contained over 200 observations. As the various rules were applied, the sample size fell. The rules which excluded most bonds were those requiring guarantees, no previous issues, monitoring by Moody’s, and identified announcement days. Descriptive statistics for the sample appear in Table 1. Some key features of the sample are these. The total number of issues is 47. The number of issuing firms is 41, since some firms sold more than one bond over the 10 years. Many types of
KEY FEATURES
Table 1 OF SAMPLE
OF EUROBONDS
Year
Number of bonds by year
Average maturity in years
Minimum/ maximum maturity
Median equity value
Median Moody’s rating
Type of issuer: I,U,Fa
1978 1979 1980 1982 1983 1984 1985 1986 1987
1 1 1 5 2 2 16 16 3
12.0 15.0 8.0 7.6 9.0 8.5 8.9 12.1’ 7.7
-
$3723b 5068 368 3672 4000 2800 4165 8344 3222
A Caa A/Baa A A/Baa A A A
Bat*)
0,0/l LO,0 LO,0 2,112 Ll,O TO,0
“1, U, and F stand for Industrial,
718 B/10 7110 5116 5130’ 3/10
10,5,1 12,2,2 2,0/l
Utility, and Financial Bonds, respectively. bMarket value of firms’ equity, in millions of dollars. In 1983 and 1984, the averages are reported. CExcludes a perpetuity. (*) The median of the yearly group’s “typical Moody’s rating” as compiled from COMPUSTAT and Moody’s sources.
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issuers are represented: 31 bonds were issued by industrial firms; the rest are almost evenly divided between bonds of public utilities and debt of financial firms (such as banks, holding companies, and insurance firms). In the sample, average maturity is near 10 years, though numerous bonds have maturities of 57 years. Most (37) of the bonds were issued after June, 1984. Over the time of the sample, the typical issuer’s market value of equity has fluctuated but shown no trend up or down. The same situation applies to the reputational capital of the firms: as data from COMPUSTAT and Moody’s show, the typical bonds rating generally stayed near “A.”
III. METHODOLOGY The methodology follows the standard approach to event studies (see Mikkelson and Partch [S], in particular). Daily abnormal, risk-adjusted returns are calculated as the difference between a stocks actual return and the return described by the single-index market model. The model’s parameters are estimated for the period running from day t = -180 to day t = -61, where the day of announcement is day t = 0. The index used throughout the statistical analysis is the CRSP Equally Weighted Index. The tests described below examine price changes over two key days: The day an announcement appears in print and the day before. Hypotheses about the cumulative average standardized abnormal returns for the two-day period of (-1,O) use the Z-statistic from Mikkelson and Partch and Kim and Stulz [7].
IV. TEST RESULTS A. Estimated
Market
Reaction
The tests focus on and try to explain the stock market’s reaction to the announcement over two days (-1,O). As KS argue, day t = -1 needs to be included because information about the upcoming sale could be available in London on that day. Table 2 contains the two-day average abnormal returns for the entire sample and selected subsamples. For each average, there is the Z-statistic for a test of difference from zero and the percentage of market responses that are positive. The first element in the table is the negative mean return (- .52%) for the entire sample, and the relatively small percentage (41%) of positive responses among the 47 observations. The Z-statistic is significant only at the 10% level, but it suggests that the typical reaction to a Eurobond announcement tends to be negative. This result differs from those of both KS and DP who find mainly positive market responses and a significantly positive mean excess return of approximately .5%. The difference probably reflects the times of the various samples. DP worked with issues offered up to 1984, and most of KS’s offerings occurred before 1985. Most of the current sample appeared after June, 1984, and
5
Differential Market Reaction to Eurobond Financing
Table 2 AVERAGE ABNORMAL STOCK RETURNS AROUND ANNOUNCEMENTS OF EUROBOND OFFERINGS (DAYS-1,O) FOR FULL SAMPLE AND SELECTED SUBSAMPLES Subsample Full sample Issued after 1984 In currency of dollar In other currency Callable bonds Non-callable bonds Industrial bonds Non-industrial bonds
Returns (%)
Z-Statistic
% Positive
hJ
-.52 -.29 -.81
-1.46b -0.95 -2.09”
41 43 36
47 37 33
.17 -.32 -.73
0.53 -0.16 -1.93”
57 49 35
14 24 23
-1.10 .07
-2.37” 0.32
50 57
24 23
“Significant at 5% level in 2-tailed test of the hypothesis dardized abnormal return equals zero. bSignificant at 10% level in similar test.
that the average stan-
the next row’s test of post-1984 issues detects no meaningful market reaction. When KS examine those issues in their sample that were sold after mid-1984, their results are very similar to those given here. Three other results in Table 2 deserve notice. Announcements of dollar bonds produce a significant mean return of -.81% with a high percentage of negative responses, while non-dollar bonds generate a positive but insignificant return (and Z-value). Notice of callable bonds produces a very small Z-value and more positive than negative reactions, while announcements of non-callable debt have a significantly negative mean return of -.73%. Finally, announced offers of industrial bonds generate a significant mean abnormal return of - l.lO%, while non-industrial bonds produce negligible reactions. The next part of this paper reports the results of general regression tests of the influence of these and other key variables.
B. Determinants
of Reaction
In the manner of KS, this paper tries to find the influences on the size and sign of the reaction to an announcement. The approach is to identify a set of plausible independent variables and to regress the two-day abnormal returns against them. Following the work of DP and KS, the chosen independent variables should reflect key features of the issuing firm and its debt instrument, an impor-
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tant element in the market at the time of the issuance of the bond, and the typical unexplained variability of non-systematic risk of the stock’s return. A description of each variable and an explanation of its expected sign follow. Indusfrial This binary variable takes on the value of zero if the issuing firm is a bank, a public utility, or a financial service company, and takes the value of unity otherwise. The work of DP first raised the prospect of a differential market reaction to regulated and non-regulated issuers, and the earlier test of means showed that the market does react differently to the two groups of bonds. However, another explanation (from Parente and Alcamo [9]) relies on the greater ability of nonindustrial firms to engage in financial engineering and more flexible financial policies during the mid-1980s when mergers and acquisitions threatened the credit quality of so many industrial firms. For either reason, the coefficient of INDUSTRIAL should be negative. Denomination This binary variable has the value of unity if the issue is denominated in dollars and a value of zero if it is denominated in yen, marks, Swiss francs, or other currency. Again, DP encouraged this line of analysis, suggesting that a non-dollar bond was more risky and hence might evoke a negative response to its issuance. Their argument was that the firm’s exposure to currency fluctuations on paying interest and principal creates the risk. It is also possible, however, that bonds denominated in non-dollar currencies probably hedge existing exposure in revenues for these multi-national firms, and that what risk there is reflects the relative volatility of the major international currencies. According to this thesis, the coefficient for this variable will be negative, signifying that the dollar’s value has been more volatile in recent years than that of most major currencies. Callabilify Whatever the causes for call provisions on corporate bonds (and a debate on that matter has been in progress for some time), there is no doubt that shareholders are pleased for the flexibility that callability provides. Hence, it is likely that the market’s response to a Eurobond offering will be more favorable and positive if that bond is callable than if it is not. As a result, CALLABILITY, a binary variable which equals 1 if the bond is callable, should have a positive coefficient. Issueprice This variable is the bonds price, as a percentage of par, as its issuance. The value of ISSUEPRICE ranges from 99% (for a discount bond) to 101% (for a premium bond). The reason for including ISSUEPRICE is that it provides some information on the state of the Eurobond market near or at the time of issuance. If the level of demand is low, the bond may sell at a discount and not produce net savings to the issuer. If demand were high, the bond’s issue price would be
Diferential Market Reaction to Eurobond Financing
7
at or above par, and this would signal benefits to issuing Eurobonds rather than domestic debt. The market’s reaction to an announcement should incorporate its awareness of the state of the Eurobond market. (It is important to note that issue day is close enough to announcement day across our sample to justify using price as an index of market sentiment at the time of announcement.) So, ISSUEPRICE should take on a positive sign in the regression; the lower (higher) the price of the issuing bond, the smaller (higher) is the market’s reaction to news of the issuance. Firmsize This control variable is defined as the natural log of the market value of the firm’s equity. Stickel [lo] proposes its inclusion as one way of counteracting possible nonconstant variance of the abnormal returns. Such variance could create cross sectional dependence of the error terms and bias the regression results. Because investors would expect large firms to exploit their access to the Euromarket, the abnormal returns around announcements are not likely to be positively associated with the size of the issuing firm. Hence, FIRMSIZE should have a negative coefficient. Non-Systematic Risk As Stickel [lo] and Mikkelson and Partch [8] point out, regression-based explanations of the prediction error around an announcement require the explicit inclusion of a measure of a firm’s typical level of unexplained variability. Only in this way can the regressions account for the different variances across firms and avoid the problem of heteroscedasticity. This variable is labeled NONSYS and is defined as the standard deviation, over the estimation period, of the residuals of the market model. It is evident that these tests do not include some variables which might be considered important to a bonds value and hence to the market reaction to its issuance. For example, maturity is omitted. In fact, some tests which contained maturity were conducted for this study; they found, as did KS, that maturity is irrelevant to the market’s response. For these reasons, maturity is not an independent variable in the test reported here. Also, the testing does not incorporate a variable for pre- and post-1984. The sample just has too few pre-1984 bonds to support a thorough test of this complex question. Further, the size of the issue is not included among the explanatory variables. One reason is that the various data sources failed to give consistent figures for the amounts of debt involved in many offerings. Often, the key financial newspapers and Moody’s sharply disagreed about the size of a bond offering. Also, most of these issues (however their sizes were gauged) were quite small compared to their firms’ total leverage. This fact, and the findings by KS that issue size is not pertinent, argue that omitting size poses no specification problem. In functional form, then, this paper’s approach to explaining the two-day abnormal returns around the event is given by this equation: ARi = KINDUSTRIAL,, DENOMINATION,, CALLABILITY, ISSUEPRICE, FIRMSIZE, NONSYSi)
(1)
GLOBAL FINANCEJOURNAL 2(1/2),1991
8
fori= 1,. . . , 48 bonds in the sample. The work of Stickel [lo] and Mikkelson and Partch [S] suggest that an equivalent but more suitable specification for estimation is this: AR*i = f(INDUSTRIALi/NONSYS, DENOMINATIONi/NONSYS, CALLABILITYi/NONSYSi, ISSUEPRICEi/NONSYSi, FIRMSIZEiINONSYSi)
(2)
where AR’, equals (ARi/NONSYSi) and is the standardized abnormal two-day return around the event. Table 3 reports on the regression results for equation (2); in that table, the original names of the variables are retained for the sake of convenience and clarity. Table 3 shows that the fit between the standardized abnormal returns and the explanatory variables is encouragingly close. The specification explains 13% of the cross-sectional variation in standardized abnormal returns, and the F-value is reasonably high. This situation represents an improvement over the results of KS and indicates that more comprehensive sets of independent variables can account for some of the wide variation in stock price reactions to Eurobond announcements. The independent variables performed in an interesting way. As expected, classification as an industrial or non-industrial company (INDUSTRIAL) is important to the size of the abnormal stock returns. The negative reaction to indusTable 3 REGRESSION RESULTS FOR TESTING DETERMINANTS OF THE MARKET’S REACTION TO EUROBOND ANNOUNCEMENTS Dependent Variable = Standardized Abnormal Return over days (-1,O) around a Eurobond announcement N = 47 Bonds Independent variablea Constant INDUSTRIAL DENOMINATION CALLABILITY ISSUEPRICE FIRMSIZE
Adjusted R2 = .13
F = 2.36~
Coefficient
t-Statistic
-0.515 -0.015 -0.016 0.014 0.022 -0.002
-1.062 -2.114b -1.995b 2.089& 1.093 -1.311’
aAl independent variables have been adjusted by being divided by NONSY&. See text for more detail bSignificant at the 5% level in a one-tail test of difference from zero according to expected relationship. CSignificant at 10% level in a similar test.
Differential Market Reaction to EurobondFinancing
9
trial bond sales is not easy to explain, but it does appear that stockholders showed some concern about the identity of the issuers. The denomination of the bonds payments (DENOMINATION) figures prominently in the market’s reaction to the announced offering, with dollardenomination leading to more of a negative response than non-dollar currencies, Such a relationship conforms to the view that the market sees the nondollar issues as covering exposure on the revenue side. The performance of ISSUEPRICE is somewhat disappointing: its coefficient is positive, as expected, On the other hand, the coefficient of but not statistically significant. CALLABILITY is also positive, as predicted, and significant. The market does care if a bond issue is callable. FIRMSIZE has the expected negative coefficient, but it is not different from zero at a significance level above 10%. Perhaps, the large sizes of most issuing firms prevent this variable from playing a meaningful role in this regression.
IV. SUMMARY The test finds a negative but insignificant reaction by the stock market to issues of non-convertible Eurobonds, most of which were announced and sold after 1984. This result differs from some earlier studies, which concentrate on pre-1984 issues. The difference in the timing and tax codes probably explains the diverging results. Further, the analysis revealed that the market response to the announcement depends on the type of issuing firm, the denomination of the bonds currency, and its call provisions.
REFERENCES “Convertible Debt Issuance, Capital [l] Dann, L.Y., and W.H. Mikkelson, Structure Change, and Financing-Related Information.” Journul of Finunciul Economics, 13:157-186 (June 1984). [2] Deshpande, S.D., and G.C. Philippatos, “Leverage Decisions and the Effect of Corporate Eurobond Offerings,” Journal of Applied Economics 20:901-915 (1988). [3] Eckbo, B. E., “Information Asymmetries and Valuation Effects of Corporate Debt Offerings,” JournaZ of Financial Econurnics, 15:119-151 (January/February 1986). [4] Finnerty, J.E., and K.R. Nunn, “The Determinants of Yield Spreads on US and Eurobonds,” Management hterrzationul Review, 25123-33 (Spring 1985). [5] Folks, W.R., Jr., and R. Aggarwal, International Dimensions of Financial Management, PWS-Kent: Boston, MA (1988). [6] Kidwell, D.S., M.W. Marr, and G.R. Thompson, “Eurodollar Bonds: Alternative Financing for U.S. Companies,” Finamid Management, 14:18-27 (Winter 1985). [7] Kim, Y.C., and R.M. Stulz. “The Eurobond Market and Corporate Financial
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Policy: A Test of the Clientele Hypothesis,” lournal ofFinancial Economics, 22: 189-205 (December 1988). [S] Mikkelson, W.H., and M. Partch, “Valuation Effects of Security Offerings and the Issuance Process,” Journnl of Financial Economics, 15: 31-60 (January/February 1986). [9] G.M. Parente and B. Alcamo, Anafomy of the Eurodohr Straight Bond Market, 1987, Bond Market Research, Salomon Brothers, Inc. (May 1987). [lo] Stickel, S.E., “The Effect of Value Line Investment Survey Rank Changes on Common Stock Prices,” Journal of Financial Economics, 14: 245-274 (March 1985).