Premium Callable Bonds and Interest Rate Risk

Here's a good NYT article on premium callable bonds, titled "It's Name Is a Mouthful, SO Just Call It a Rate Shield". It begins:

After months of false alerts, longer-term interest rates may finally be moving up in earnest. If the trend continues, fixed-income investors who have not prepared will be taught an ugly lesson: as yields rise, prices fall and the value of a bond portfolio declines.

But there are ways to minimize the pain. The most common moves are to sell longer-term bonds and to hold cash or shorter-term securities, which won't be hurt as badly as their cousins with longer maturities. Some portfolio managers also use futures contracts to hedge against rate increases.

But professionals are also using a less known way to cushion a bond portfolio: by buying premium callable bonds.

The article is a good one to use when discussing duration (a measure of how far off in the future the cash flows from a financial security are on average). Duration is a measure of a bond's price sensitivity to interest rates, because the present values of distant cash flows are affected by changes in interest rates more than are the present values of cash flows that are closer in time to the present. Premium callable bonds have lower duration for a number of reasons:

1. The bond are selling at a premium becuse they pay a coupon rate that is higher than the rate on bond that sells at par. So, since a bond's cash flows consist of coupon payments and a lump sum at the end, a premium bond has relatively more of its cash flow in the form of coupon payments (which occur before maturity).
2. Since the bond is at a premium, it is more likely to be called. So, the "term" if the bond is likeley to be much shorter, resulting in a shorter duration.
   

The article then concludes with a few scenarious where a premium callable bond has some increased risks.

Different Opinions, or Evil?

Jane Galt at Asymmetrical Information gives some good advice on how to approach & deal with those who hold different opinions than your own:

Absolutely outstanding post by Stuart Buck about one of my pet peeves, the common belief that people who disagree with you are amoral lackwits, rather than putting different relative weights on principles we mostly all cherish:

People often accuse their opponents of being hypocrites when, in fact, they ma simply have been balancing competing principles. We all do this constantly. And the mere fact that someone reaches a different balance than you, or that they decline to treat one principle alone as being absolute, does not prove that they are being hypocritical.

Click here for the whole article.

Excellent advice - people I disagree may be misguided or illogical, but they aren't necessarily evil. Once you start demonizing your opponents, you're no longer discussing things in order to win them over, but instead in order to reinforce your own beliefs.

Updated Blog Roll

There are a number of blogs I check on a regular basis. - I just hadn't gotten around to updating the blogroll. Now I have - I've just added about a dozen new ones. Check them out, and see if anything tickles your fancy.

If you have any suggestions on links I should add (whether to your blog or to those you frequent), email me and let me know.

One Billion Lnks

From the Folks at Crooked Timber:

I wasn’t watching it tick over, and I missed the party but Technorati just passed 1 billion links, of which this blog accounts for 311.

Click here for the whole (albeit short) post.

Editorial comment: Crooked Timber is one of my favorite blogs. They usually have a point of vies that's very different (and often diametrically opposed) to mine, but that's what makes it fun. If you haven't already, consider adding them to your "regular read" list.

Along those lines, if you haven't already done so, check out Bloglines. It's a good way to keep up on your blog reading without spending all day. My current subscription list contains over 50 sources, and I can usually check it for new posts in about 2 minutes.

An Insider Looks at The Tribe

To those not in "The Tribe", academia can be a strange place. To those in it, it can be even stranger. Tyler Cowen at Marginal Revolution the latest edution of Econ Journal Watch. While he mentions the tribute to Thomas Schelling, there's another article in the same journal, titled "The Ph.D. Circle In Academic Economics" (click on the page link in the table of contents) that's also a great read. It goes at great lengths into how the "market for ideas" among economists is very different than the market for just about anything else. These types of analyses are typical conversation for colleagues of mine, but we don't say it as well as this article. The section titled "If Waiters Were Like Economists" is particularly good:

Do the thought experiment. You arrive on a planet on which the market for waiters is like our market for academic economists. This otherworldly market exhibits the following features:

• Each waiter job is controlled by a collection of other waiters, a Waiter Department.
• Each Waiter Department spends money with very slight regard for the preferences of restaurant customers. Indeed, much of the money comes from coercive extractions from extraneous parties.
• There are 200 Waiter Departments, but they all form an encompassing mono-centric cultural pyramid. Each Waiter Department gets whatever prestige and revenue-base it commands principally by adhering to the accustomed standards of the encompassing club.
• Each Waiter Department produces the new young waiters, whom it tries to place as high up in the pyramid as possible.
• Non-waiters are deemed unqualified to criticize the standards and practices of the encompassing Waiter club. Outsiders are ignored.
• Waiters at departments at the top of the pyramid set the tone for the entire club.
• Waiters carry on political discourse with restaurant customers.
• Moreover, waiters at the top departments rub shoulders with political elites and power-holders. Sometimes, the top Waiters are appointed to positions of influence and power. Many aspire to be or imagine themselves to be part of society’s governing set. Their governing-set standing depends on playing according to the rules of conventional political culture. One of those rules is that one must accept the idea that society is an organization and government is the manager of that organization. One must affirm a basic faith in democratic political processes. One must observe that the appointed managers are like us, smart, socially-concerned people who can master the contours of society’s unknowability well enough to regulate social affairs beneficially. One must refrain from saying anything that might imply that much of what the government does is fundamentally a sham and a menace. As a result, among the top 50 Waiter Departments there is no voice or vitality for abolitionism.

It explains a lot, and should be read by anyone considering a Ph.D. in finance or economics.

The Plagiarist And The Comedian

A college student goes on the internet and asks a stranger (Nate Kushner at A Week Of Kindness) to write a paper for her. Unfortunately for (and unbeknownst to) her, he's a comedian with some free time on his hands who doesn't like plagiarists. So, he strings her along and then turns her in. The story that follows is either poetic justice or the makings of a new urban legend.

Make sure you read the comments too. They're split between "good for you - she git what she deserved" and "that was WAAAAY too harsh".

Since I just had to deal with three cheaters on my last exam, you can guess what side I'm on.

Compensation, Governance, and Fraud

This from The Atlantic (by way of Jane Galt at Asymmetrical Information):

Corporate scandals often happen at the most successful firms—or at least at firms where the appearance of success breeds a megalomaniac CEO, reams of stock options, overoptimistic goals, and gaga recommendations from Wall Street equity analysts. This is the conclusion of a Boston Consulting Group study that analyzes the companies responsible for twenty-five of the largest corporate frauds since 1996. Compared with their clean competitors, "fraud firms" offered their CEOs eight times as much stock-based pay and set corporate performance targets 250 percent higher. Other factors associated with executive malfeasance were inflated stock prices and attention from the press (before their downfalls, fraud-firm CEOs were three times as likely to be quoted in the media as their competitors). Moreover, two interesting insights emerged. First, good corporate governance—of the sort mandated by post-bubble regulations—may have done little to prevent fraud. Enron's board, for instance, was rated among the nation's five best-governed in 2000. Second, while crooked execs may have fooled analysts, the media, and the public, the market sniffed them out. The median fraud firm lost 40 percent of its value in the year before its actions came to light. (One wonders who was selling …)

—"Corporate Governance Revisited: How Greed and Ego Can Destroy Companies and the Lessons to Be Learned," Kees Cools, Boston Consulting Group [This item is unavailable online.]

There have been a number of academic studies that are closely related to this news. They examine factors related to earnings restatements (rather than fraud), but the two events are pretty closely related):

1) Palmrose, Richardson and Wu that examined what factors predict earnings restatements :

...firms restating earnings have high market expectations for future earnings growth and have higher levels of outstanding debt. We also find that a primary motivation for the earnings manipulation is the desire to attract external financing at a lower cost. Furthermore, our evidence suggests that restating firms have been attempting to maintain a string of consecutive positive earnings growth and consecutive positive quarterly earnings surprises. Together, our evidence is consistent with capital market pressures acting as a motivating factor for companies to adopt aggressive accounting policies.

Click here for a copy of the working paper from the SSRN.

2) A paper by Agrawal and Chadha in the Journal of Law and Economics:

... We find that several key governance characteristics are unrelated to the probability of a company restating earnings. These include the independence of boards and audit committees, and the provision of non-audit services by outside auditors. We find that the probability of restatement is lower in companies whose boards or audit committees have an independent director with financial expertise; it is higher in companies where the CEO belongs to the founding family.

The article isn't available online, but an earlier version (also on the SSRN) can be found here.

The first piece is consistent with executives having incentives to manipulate earnings to enhance corporate "reputation" (if we construe the term "reputation" broadly to include the need to be able to attract funds at a reasonable price). In particular, firms more likely to need external financing (i.e. higher growth firms) are more likely to manipulate their earnings.

The second piece board governance matters in constraining earnings manipulation, but that the simple "is the board independent" measure is not the best way to capture how well the board is governing. It's more important that the board members be "smart". Other words, the key seems to be the presence of a "sophisticated" independent director (one with financial expertise). Several years ago (pre-SOX), ther was a study that found that the typical independent director spends less than three hours a week on board-related duties. Given this relatively short time commitment, it's tough to do any effective monitoring unless you really know what you're doing.