At the end of my initial post on financial innovation, I listed a handful of financial innovations that I considered beneficial. (I didn't mean to list both zero-coupon bonds and Treasury STRIPS, since STRIPS are obviously zeros—the most important zeros, in fact.) I was mainly focusing on financial products that no one has yet mentioned as being beneficial in the financial innovation debate, which is why I omitted obvious examples like ETFs. Anyway, here, at last, is my argument for why medium-term notes and zero-coupon bonds are clearly beneficial financial innovations. (Next up: project finance and puttable bonds.) Medium-Term Notes A medium-term note (MTN) is a debt security offered to investors continuously over a period of time as part of an MTN program. Essentially, a company establishes an MTN program by filing a so-called "shelf registration" with the SEC describing, broadly, the types and total amount of securities they reasonably expect to sell under the program in the next two years. (Rule 415 covers shelf registrations.) After the SEC declares the shelf registration effective, the company can sell a wide variety of securities under their shelf-registered MTN program for the next two years on a moment's notice, and without having to file separate registration statements for each debt issue. Unlike conventional corporate bonds, which are underwritten, MTNs are generally distributed on an agency basis, with 3 or 4 investment banks acting as agents for each MTN program. An issuer will post offering rates with its agents for a range of different maturities: 9 months to 1 year, more than 1 year to 18 months, more than 18 months to 2 years, and so on up to any number of years. Issuers can change their offering rates in response to, say, a lack of investor interest, or a change in interest rates. An investor interested in purchasing notes at the offered rate will contact the issuer's agent, who then arranges the transaction. Investors are generally allowed to choose the exact maturity date within a given maturity range, which allows them to more precisely match the maturities of their assets and liabilities. (This is obviously an (extremely) abridged description of MTNs. For people who want a more complete description, I've extracted the chapter on MTNs in Marcia Stigum's Money Markets—mainly because I've just discovered how to extract sections from PDF files, and now I'm an extracting machine! For an example of an active MTN program, see here, or see Freddie Mac's MTN program here.) The main reason I immediately thought of MTNs as a beneficial financial innovation—though there are better reasons, described below—is a process in the MTN market called "reverse inquiry." Say a mutual fund needs $6.5 million of A3-rated paper with a maturity of 4 years and 6 months, but no such paper is currently available in the MTN market. The mutual fund could contact one of the major MTN agents, who would then go to the A3-rated issuers it represents with the mutual fund's proposed terms. If an issuer is satisfied with the proposed terms, a deal can be struck and the issuer can sell the custom-tailored security out of its MTN program that day. (The issuer is essentially taking the securities it registered with the shelf registration statement "off the shelf.") Reverse inquiries are actually quite common, and they account for a large share of total MTN transactions. The most exotic MTNs usually result from reverse inquiries—a fund manager may be exposed to some weird risk which necessitates paper that's linked to a random equity index or exchange rate or something. But this isn't a case of investment banks dreaming up exotic (and risky) securities and selling them to unsuspecting investors. Exotic MTNs that result from reverse inquiries are, by definition, driven by the needs of investors. More broadly, MTNs bridged the gap between commercial paper and traditional corporate bonds. For regulatory reasons, commercial paper can't have a maturity at issue of more than 9 months. That meant that prior to MTNs, any company that wanted to issue debt with a maturity of over 9 months had to register each debt issue separately, which was—and still is—both expensive and time-consuming. One of the reasons that traditional corporate bonds trade in such size ($100 million is an unofficial minimum) is that the legal, accounting, and printing costs of registration are so high. This is on top of the generous underwriting fee that seasoned issuers (the biggest beneficiaries of MTNs) paid to their "usual" investment bank. These costs made it prohibitively expensive to sell smaller and shorter-dated securities (i.e., maturities of 9 months to 2 years). This minimum-offering-size issue, as well as other conventions in the corporate bond market, such as the clustering of maturities around 2, 3, 5, 7, and 10 years, really limited issuers' options, and ultimately raised their borrowing costs. MTNs changed all that, making it cost-effective for companies to sell smaller debt issues at non-standard maturities, and often with terms that better suit both the issuer's and the investor's specific needs. MTNs also increased competition among underwriters by allowing issuers to engage multiple investment banks as agents for their MTN programs. The increased competition significantly reduced investment banks' fees, lowering issuers' borrowing costs even further. (The notion that increased competition can lead to lower underwriting fees seems almost quaint nowadays, but it was not always so.) That, to me, is a beneficial financial innovation. Zeros (and STRIPS) Zero-coupon bonds (known as "zeros") are bonds that pay no interest, but instead promise a single payment at maturity. Since investors receive no coupon payments over the life of the bond, zeros are sold at a discount to their face value. Any conventional couponed bond can be considered a series of zero-coupon bonds—each coupon is simply a promise to make a single payment on a specified date. Consequently, a conventional 5-year note can be "stripped" into its 10 coupon payments and a principal repayment, creating 11 separate zero-coupon bonds. Merrill created zeros in 1982, when it stripped a series of Treasury long bonds. Other investment banks quickly started selling privately stripped Treasury zeros as well. The Treasury Department finally started allowing direct stripping of Treasuries in 1985, when it instituted its STRIPS (Separate Trading of Registered Interest and Principal Securities) program. Treasury zeros, which are commonly referred to as STRIPS, are created via the Fed's book-entry system—when a Treasury is stripped, each coupon payment and the principal payment becomes a separate zero-coupon bond with its own CUSIP. Stripped Treasuries can also be reconstituted via the book-entry system. So how have zeros been beneficial? They eliminate reinvestment risk, which has made them perfect for pension funds and insurance companies, which need long duration and certainty in their returns. STRIPS, in particular, offer maximum certainty: the U.S. Treasury is the safest borrower in the world, and, as zero-coupon bonds, STRIPS also eliminate reinvestment risk. The certainty and long duration of STRIPS have been absolutely crucial to the ability of pension funds and insurance companies to reliably and predictably match the cash flows of their assets to the benefits payments they make. Zeros are more sensitive to changes in interest rates than conventional couponed bonds, which can lead to short-term volatility in prices, but that generally hasn't been an issue for long-term, buy-and-hold investors like pension funds. Also, zeros prices are something of a theoretical building-block in modern financial models. The large and liquid market in STRIPS, for instance, has provided accurate prices across a range of maturities, which is actually pretty important, especially for banks and other investment funds who rely on things like the zero-coupon Treasury yield curve in their pricing models. (In fact, the question of why it took the financial industry so long to create a product as fundamental and seemingly obvious as zero-coupon bonds is still something of a mystery in finance circles.) This isn't the most important benefit of zeros, to be sure. But it's not insignificant either, and I think we can all agree at this point that better financial models are a good thing.


Anonymous said...

Shouldn't these be classified as "micro-innovations" i.e. the working out of the details of earlier innovations (i.e. corporate debt) through numerous small improvements over time? (See Mokyr, Lever of Riches)

Henri Tournyol du Clos said...

Re : "In fact, the question of why it took the financial industry so long to create a product as fundamental and seemingly obvious as zero-coupon bonds is still something of a mystery in finance circles".

Well, no, that is not the right question, there were numerous antiquated regulations that prevented the emergence of zeros at the time, a quarter of a century ago, notably their tax treatment in many parts of the world, which remained a fuzzy subject until the mid-nineties.

What is really worrying is that they never really took off and are a mere 5% of Treasury securities and a negligible part of corporate debt.

The same can be said of MTNs, which should have replaced corporate bonds a long time ago but did not.

Surprisingly, many of the core financial markets are built around inefficient, medieval instruments. Even the IRS market, a modern, adaptive market if there ever was one, is built on Libor, a thoroughly obsolete instrument (which incidentally blew up big time in 2007/2009).

Anonymous said...

Okay, so when you said there were examples of beneficial financial innovations, there was a resounding cry of "Like What?" from the rest of the web.

Now that you've thrown a couple of examples out there, did any of those people acknowledge it?


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