2.5More Exotic Securities

One of the chief characteristics of financial markets is their ability to develop innova-

tive financial instruments. This section explores a few examples of these innovations

and the forces that drive them.

Tax and Regulatory Frictions as Motivators for Innovation

Firms issue innovative securities for many reasons, but two of the most important are

to escape the bite of taxes and regulation. The following is an example of a dual-

currency bond, an exotic innovative security driven by regulation.

RJR’s Dual-Currency Bonds

As part of the financing of RJR’s acquisition of Nabisco in 1985, Morgan Guaranty Trust

suggested a dual-currency Eurobond (defined shortly). The bond would pay the annual

coupons in yen, but the principal would be repaid in dollars.

There was a peculiar regulatory reason for issuing the dual-currency bond. Japanese

insurance funds could pay dividends to policyholders only out of the cash yield of invest-

ments. Thus, their need for high-coupon bonds was great. The bond suggested by Morgan

had a coupon of roughly 150 basis points higher than a competing straight Euroyen bond.

The larger coupon was compensated for by a favorable implicit forward currency exchange

rate that translated the yen principal into dollars.

¹⁶Moody’s —that is, what fraction of principal is recovered after a

(1994) estimates recovery rates

default has occurred—as varying from about 40 percent to 60 percent for corporate bonds. Bank debt

recovery rates tend to be about 20–30 percent higher.

Grinblatt128Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw128Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

52Part IFinancial Markets and Financial Instruments

The Japanese insurance companies were willing to take a loss at maturity in return for

higher coupons along the way. The dual-currency Eurobonds were much like private place-

ments because they were presold to the insurance companies and there was no secondary

market trading for them. Regulations also prohibited Japanese firms from holding more than

10 percent of assets in foreign securities. Despite the dollar payment at the end, the dual-

currency bond was not counted as a foreign security. RJR was able to issue the bond at just

30 basis points above Treasury yields at a time when other recent issues were priced to

yield 50 to 100 basis points above Treasuries.

Source: Kester and Allen (1991).

Collateralization as a Force for Innovation

Other recent innovations include the creation of asset-backed securities, which are

securities that are collateralized by cash flows from assets, like mortgages and accounts

receivable. The mortgage-backed securities market is perhaps the pioneer in this vein,

but other interesting examples abound. Asset-backed securities have become one of the

cheapest ways of turning an asset like receivables into ready cash.

In March 1994, for example, Northwest Airlines brought the first airline industry

asset-backed certificates to the market. They were backed by Northwest’s accounts

receivable—their ticket payments. The receivable certificates were sold in a private

placement, priced at LIBOR plus 87.5 basis points with a cap at 12 percent. Even

though Northwest was not in good financial shape, since the certificates were backed

by receivables, they obtained a AArating.¹⁷Similar asset-backed securities have been

issued by credit card companies and automobile financing units.

Macroeconomic Conditions and Financial Innovation

Occasionally, conditions that influence the macroeconomy, such as oil prices or infla-

tion, lead to innovative debt securities. For example, during the 1989 Kuwaiti crisis,

crude oil prices skyrocketed to about $40 per barrel although long-term oil prices, rep-

resented by prices in the forward market, were far lower. Several firms were convinced

by their investment banks that it was a good time to issue oil-linked bonds. Such bonds

were characterized by lower than normal coupon rates, allowing the corporate issuer to

save on interest payments. To compensate investors for the low coupon rate, the prin-

cipal to be paid was either four times the per-barrel price of crude oil at the maturity

of the bond or $100, whichever was larger. Salomon Brothers was one firm that showed

its corporate clients how to hedge the oil price risk of the principal payment by enter-

ing into forward contracts for oil.

Another example is Treasury Inflation Protected Securities (TIPS). First

begun in 1997, these Treasury notes and bonds pay a lower coupon rate than nor-

mal Treasury securities, again saving the issurer (the U.S. government) a sizable sum

in the short run. To compensate investors for the lower coupon, the principal on

which the coupon is paid grows each year—by the rate of inflation as measured by

the urban consumer price index. Similar securities have long been issued by other

nations, such as Israel and Canada, as well by businesses in countries with high rates

of inflation.

¹⁷Financing

Foreign Operations, Economist Intelligence Unit, March 1995.

Grinblatt130Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw130Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 2

Debt Financing

53

Financial Innovation in Emerging Capital Markets

Other frictions in the financial markets of some countries may drive financial innova-

tion. Firms located in countries with emerging capital markets can be just as inventive

as U.S. firms. In 1994, Avtovaz, a Russian automobile manufacturer, issued 300,000

bonds convertible into Ladas, the car it makes. If held to maturity, an Avtovaz bond is

redeemable for one Lada. For people who wanted an automobile, buying the Avtovaz

bond was an easy choice; at the time, the only other way to get a car in Russia was to

pay a bribe to be put at the top of the waiting list.

Another Russian example is Komineft, an oil company, issued zero-coupon bonds

whose principal was tied to the dollarprice of oil. Investors were thus protected against

the decline in the value of the ruble caused by Russian inflation.¹⁸

The Junk Bond Market and Financial Innovation

The junk bond market also has been a driving force for innovative security design.

Once the junk bond market took off, many innovations followed. Instead of straight

bonds with high coupons, firms began to issue bonds with special features and

embedded options. Thus, they created Zerfix bonds (short for zeroand fixed

coupons), a deferred coupon bond that consisted of an initial zero coupon followed

by a fixedcoupon after three to seven years. Zerfix bonds were intended to help the

issuing firm conserve cash. Similarly, firms issued PIK bonds, which gave them the

option to pay either in cash or in additional bonds. As an implicit promise to retire

or refinance debt, firms sold increasing-rate notes (IRNs), which required the firm

to increase the coupon quarterly at a predetermined rate in the range of 20–50 basis

points.

APerspective on the Pace of Financial Innovation

The pace of financial innovation has been remarkable given that new security designs

cannot be patented, are easily copied, and, once copied, their profitability to the inven-

tor drops dramatically.¹⁹

To encourage such a rapid pace of innovation, successful secu-

rity designs have to be phenomenally profitable to the inventor for that brief period of

time before competitors introduce imitations.

Will the pace of financial innovation ever slow down? As long as governments

continue to tax, regulate, and restrain trade, firms will devise ways to minimize taxes,

reduce the effectiveness of regulations, and overcome trading frictions in the economy.

Therefore, we expect financial innovation to continue.