A survey of US corporate financing innovations: 1970–1997

Abstract

An appropriate subtitle for this article might well be “The Evolution Lives! Long Live the Evolution!” Previous articles in this journal have described innovations in financial security design and the forces that give rise to such innovations.1 In this article, we expand upon and update those articles by documenting changes over the past 30 years in the way US public corporations finance themselves both in public and private security markets.2

The past articles have focused mainly on innovations in the kinds of securities issued. But major changes have also occurred in the way securities are issued, and in the national markets where they are issued. Traditional registered offerings have been partly displaced by shelf registered offerings and Rule 144A private offerings. And once exclusively domestic US offerings are increasingly being supplemented by foreign market offerings by US companies, and by simultaneously domestic and foreign offerings. In the research summarized in this article, we tracked not only the kinds of securities (both by number and by dollar amount) issued each year by US public companies between 1970 and 1997, but also their method of issuance and the locale of the offerings.

In a 1992 article in this journal entitled “An Overview of Corporate Securities Innovation,” John Finnerty traced innovations (through the first half of 1991) in the design of securities issued by US corporations by identifying the year in which the design first appeared.3 Our study extends that article's findings in two ways: (1) by updating developments in the design of corporate securities through the end of 1997 and (2) by presenting an annual time series of security issues classified according to the design of the security from 1970 through 1997.

Our updating of new developments in security design provides clear evidence that the pace of innovation in securities design has not slackened. For example, whereas Finnerty identified 40 types of securities that were first issued by US companies in the 1980s,4 our study found 34 kinds that were first issued during the first eight years of the 1990s.5 Among these securities were equity indexed bonds, commodity indexed preferred stock, convertible exchangeable notes, and dividend enhanced convertible securities.

Our study also attempted to identify which innovations have prospered over time and which have languished or even disappeared. For example, the first non-convertible floating rate note (FRN) was issued in 1974. The use of FRNs increased steadily throughout the next 24 years and, in 1997 alone, US public companies issued 1411 FRNs with an aggregate face value of $139.8 billion. By contrast, after the first convertible adjustable rate bond (CARB) came to market in 1981, 10 additional CARBs were issued during the remainder of the 1980s, and none have been issued since. Our findings suggest that financial innovation is a trial and error process in which “failure is more likely than not.”6

Publicly traded US companies can issue securities exclusively to US investors, exclusively to non-US investors, or simultaneously to US and foreign investors. The three panels of Table 1 display the number and dollar amount of security offerings for each year from 1970 through 1997. Panel A shows public and private offerings in the United States; Panel B shows public and private offerings made simultaneously in the United States and one or more foreign country; and Panel C reports offerings made in one or more foreign countries. Before describing the different types of securities issued, we focus on the data in Table 1 to provide an overview of offerings in the aggregate by offering technique and locale.

In tracking the process of securities innovation, we started by classifying all securities employed by corporate issuers since 1970 into six generic categories: (1) common stock, (2) non-convertible debt, (3) convertible debt, (4) non-convertible preferred stock, (5) convertible preferred stock, and (6) asset backed securities. Then, within each of the six categories, all securities were identified as either “traditional” or “innovative.”

For our purposes, a traditional non-convertible debt is any callable or noncallable non-convertible bond or note with a fixed periodic cash coupon payment, a fixed final maturity date, and fixed repayment schedule. A traditional convertible debt is defined similarly, except that the security is convertible into the common stock of the issuer at the option of the investor. Convertible and nonconvertible bonds or notes with any other feature are categorized as innovative.

A traditional non-convertible preferred stock is any callable or noncallable non-convertible preferred stock with a fixed periodic cash dividend and no fixed maturity date.7 A traditional convertible preferred stock is defined similarly, except that the security is convertible into the common stock of the issuer at the option of the investor. Convertible and non-convertible preferred stock with any other feature are considered innovative.

Asset-backed securities (ABS) do not fit neatly into our classification scheme because of the absence of a “traditional” ABS. Thus, by definition, all ABS are innovative. Conversely, all common stocks, because of their homogeneity, are treated as traditional.8

The results of our classification scheme are presented in Table 2. In 1970, of the 1124 securities issued, only one—an offering of zero coupon convertible debt—is classified as innovative. Over the period 1970 through 1975, 12 of 6132 issues are identified as innovative. But, as we move into the 1980s, the pace of innovation begins to quicken. In 1985, 317 of 2405 (or 13% ) issues are classified as innovative. And, in 1997, 2644 of the 9387 (28% ) issues fall into the non-traditional category. Expressed in dollar terms, $314.5 billion of the $902.3 billion (or 35% ) raised through all 1997 offerings were accounted for by innovative securities.

The fraction of securities classified as traditional and innovative securities varies across the six generic categories. As we noted, there are no innovative securities in the common stock category and there are no traditional securities in the asset-backed category. Among debt securities, traditional offerings outnumber innovative offerings every year in both number and dollar amount. In 1997, the $456.2 billion of traditional non-convertible and convertible debt offerings was 2.2 times the $211.4 billion issued in innovative debt securities. In the case of preferred stocks, by contrast, there are some years in which innovative offerings exceed traditional offerings. Between 1982 and 1997, $153 billion in straight and convertible preferred stock issues qualified as innovative issues while only $142 billion qualified as traditional issues. The tax advantage of preferred stock securities (i.e., 70% of dividends received are not taxable) may play an important role in the dominance of innovative preferred stock issues relative to traditional preferred stock issues. In addition to their tax advantage, preferred stock innovations like MIPS and QUIPS also feature variable dividend payments that reduce price volatility for investors and may allow issuers to manage interest rate risk.

This article examines the financing of publicly traded US corporations in public and private security markets from 1970 through 1997. We document significant changes during this time period in the method of issuance (traditional registered offerings, shelf registered offerings, private offerings, and Rule 144A private offerings), the national locale of the offerings (domestic, simultaneous domestic and foreign market offerings), and the kinds of securities issued.

The Securities Exchange Commission (SEC) implemented Rule 415 (shelf registration) in 1982 and Rule 144A in 1990. Based on volume, these new procedures have been very successful. In 1997, nearly half of all publicly offered securities were issued as shelf registered offerings. Of private market offerings made by US corporations in 1997, Rule 144A offerings accounted for 83% of proceeds.

The internationalization of capital markets is also evident. In 1997, 11% of all proceeds raised by US corporations were issued in one or more foreign markets. Of the $105 billion raised in these offerings, $31 billion was denominated in currencies other than the US dollar. For corporations with foreign currency cash receipts, foreign currency debt payments provide a long-term hedge against exchange rate volatility.

Since 1970, publicly traded US corporations have used 76 different varieties of innovative securities to raise over $1.7 trillion in the domestic capital markets. While traditional securities still dominate the market, our research indicates that the pace of financial innovation increased markedly during the 1980s and has continued strong throughout the 1990s. In 1997, the 2644 issues of innovative securities accounted for almost 30% of total domestic offerings; and these 2644 issues raised 37% ($315 billion) of the total proceeds from all US offerings.

Three of the most common objectives of innovative security design have been to (1) manage the interest rate (and other financial price) risk faced by investors and issuers; (2) to reduce information costs faced by investors when buying securities from issuers with better information about their own prospects (a condition known as information asymmetry); and to (3) increase the tradability of financial assets.

Interest rate-linked coupon payments such as those used in floating rate notes are the most common features used to reduce both the interest rate risk faced by investors and hence the real interest cost to the issuer.16 Interest rate-linked securities account for 63% of all innovative issues and 48% of proceeds between 1970 and 1997. Although such securities may seem to transfer interest rate risk from the investor to the issuing corporation, some issuers may have a comparative advantage in bearing such risk—particularly those whose revenues tend to increase with higher inflation and interest rates and inflation.

Another popular security, puttable notes or bonds (which in 1997 raised $32 billion, or 10% of total proceeds from innovative issues), also reduces investors’ exposure to increasing rates by allowing them to put their bonds back to the issuer. But a more important attraction for investors is the protection puttable securities offer against a deterioration of the issuer's credit quality. In this sense, puttable securities may enable somewhat riskier issuers to overcome the information costs arising from investor uncertainty about the firm's future prospects.

Another entire category of securities innovation, namely ABS, has also been used by lower-rated issuers to reduce asymmetric information costs.17 ABS (not including mortgage-backed securities) have grown substantially, with proceeds ratcheting up from $1.2 billion in 1985 to $77 billion in 1997 (and representing 25% of innovative security proceeds). Because the ABS process segregates a set of high quality assets (typically receivables) into a special purpose security, the values of ABS are based solely on the cash flows and risk of the underlying asset class, not on the expected cash flow performance of the issuing firm. Besides reducing investor uncertainty in this manner, asset securitization may also add value by increasing the tradability of financial assets. Increasing the tradability of financial assets may reduce investors’ required rates of return and hence issuers’ overall financing costs.

In sum, US capital markets in the 1980s and 1990s were distinguished by both innovation and internationalization. While some securities have languished or even disappeared, others have prospered. As securities continue to be redesigned to meet the specific needs of issuing firms and investors, we expect further internationalization of the capital markets and continued growth in the quantity and dollar volume of innovative securities.