A Corporate Bond Market Primer

According to a recent article in CFO, about $4 trillion in corporate debt was issued in 2012, besting the previous high of $3.89 trillion in 2009. But what may be more interesting in the article is a primer in the workings of the bond market. Before shelf registration was adopted in 1982, investment banks spent considerable time and effort premarketing bond offerings, essentially a road show for bonds sold in the primary market. After the advent of shelf registration, investment banks had less time for premarketing bonds so they essentially purchased an entire bond issue off the shelf and sold the bonds, taking all of the pricing risk of the new issue. Recently, investment banks appear to have gone back to premarketing bond issues. The downside to this model is that investment banks have reduced incentives to sell smaller, more complex bonds and instead focus on larger, regular bond offerings. Additionally, there appears to be evidence that the current method of using a syndicate to premarket bond offerings increases the yield premium on new bonds about 10 basis points higher than it should be.

Buffett's Warrants

Since our last post questioned Warren Buffett's math skills regarding dividends, we felt like we should make it up to him by posting about his skill with warrants. In 2008, during the middle of the financial crisis, Buffett bought $5 billion of preferred stock in Goldman Sachs with a 10 percent dividend, along with 5-year warrants to buy Goldman Sachs stock at a price of $115. If Buffett exercised the warrants today with a payment of an additional $5 billion, he would own 9 percent of Goldman. In a deal between the parties, Goldman issued Buffett shares amounting to about 2 percent of the company at no cost! The deal appears to benefit both parties as Buffett does not need to spend $5 billion today (and has received a 10 percent dividend over the past five years) and Goldman's dilution is only 2 percent of its stock, not 9 percent.

Buffett's Dividend Irrelevance

Many investors view Warren Buffett, the Oracle of Omaha, with a great deal of reverence. For that reason, most people never doubt his comments, but we are not most people. In his recent letter to Berkshire Hathaway shareholders (see page 19), Mr. Buffett extols the virtue of dividends that Berkshire receives from the companies that it owns. In fact, he states that “we relish the dividends we receive from most of the stocks that Berkshire owns,” while at the same time steadfastly refusing to pay dividends to Berkshire shareholders. Does that sound a little like your parents telling you “Do what I say, not what I do?”

Mr. Buffett justifies his views with an example that is eerily similar to the Modigliani-Miller dividend irrelevance argument, but he makes a mistake as pointed out in this letter to Mr. Buffett from Brad Jordan (coauthor of our favorite textbook). We'll let you know if we get a response.

Foreign Cash Balances Grow

U.S.-based companies saw their offshore cash balances grow by $183 billion last year, to more than $1.9 trillion. One of the main reasons for the growth in offshore cash balances by U.S. companies is the worldwide tax system, which requires U.S.-based companies to pay income tax on earnings from any country when repatriated. In contrast, most other industrialized countries charge little, if any, tax on foreign earnings. The comparison of international tax rates can be seen by examining the potential taxes owed by Microsoft and Citigroup on foreign cash balances. Microsoft would owe $19.4 billion if it repatriated its $60.8 billion in offshore cash, implying it had paid a foreign tax rate of 3.1 percent. Meanwhile, Citigroup would owe $11.5 billion in taxes on its $42.6 billion in foreign tax, implying a foreign tax rate of 8 percent.

Delisting Increases

The Jumpstart Our Business Startup (JOBS) Act is allowing companies to deregister from stock markets. Previously, a company with over 500 shareholders was required to be listed, which also meant filing financial reports with the SEC. The JOBS Act allows companies with as many as 2,000 shareholders to delist, and allows the company to avoid SEC reporting requirements. The Coastal Banking Company recently delisted its securities, saving $150,000 to $200,000 per year. And Harleysville Savings Financial saved 6 cents per share by delisting. While going dark used to have negative connotations, OTC Markets is trying to make unregistered securities more respectable. OTC Markets has five tiers of stocks based on the information made available by the company. OTC Markets combines the company's financial results with the stock price and trading information in an effort to increase transparency.