The Structure of the Bond Market and the Cyclical Variability of Interest Rates

STATISTICS on the movements of interest rates over time suggest that there can be only limited adjustments of rates for the purpose of carrying out anti-inflationary and anti-deflationary monetary policies. Although short-term rates, which may be significant for inventory changes and for balance of payments problems, show considerable variability, those rates which are most likely to influence investment outlays do not. The statistics indicate that changes as large as two percentage points (e.g., from 3 per cent to 5 per cent) in long-term interest rates have rarely been brought about within the space of 12 months. Within the span of a few months—perhaps the longest adjustment period that successful monetary policy can permit—the variability of long-term rates is considerably smaller; changes of even one percentage point have been rare.


STATISTICS on the movements of interest rates over time suggest that there can be only limited adjustments of rates for the purpose of carrying out anti-inflationary and anti-deflationary monetary policies. Although short-term rates, which may be significant for inventory changes and for balance of payments problems, show considerable variability, those rates which are most likely to influence investment outlays do not. The statistics indicate that changes as large as two percentage points (e.g., from 3 per cent to 5 per cent) in long-term interest rates have rarely been brought about within the space of 12 months. Within the span of a few months—perhaps the longest adjustment period that successful monetary policy can permit—the variability of long-term rates is considerably smaller; changes of even one percentage point have been rare.

STATISTICS on the movements of interest rates over time suggest that there can be only limited adjustments of rates for the purpose of carrying out anti-inflationary and anti-deflationary monetary policies. Although short-term rates, which may be significant for inventory changes and for balance of payments problems, show considerable variability, those rates which are most likely to influence investment outlays do not. The statistics indicate that changes as large as two percentage points (e.g., from 3 per cent to 5 per cent) in long-term interest rates have rarely been brought about within the space of 12 months. Within the span of a few months—perhaps the longest adjustment period that successful monetary policy can permit—the variability of long-term rates is considerably smaller; changes of even one percentage point have been rare.

One observer states that the limit to variations in the yield of British consols for countercyclical purposes is “a fraction of 1 per cent.” And up to the 1950’s the cyclical variations in the U.S. corporate bond yield series had been practically imperceptible.1

For Great Britain, two characteristics of the statistical series used have misrepresented the variability of long-term interest rates. First, the conventional procedure has been to represent long-term interest rates by the yield on consols (perpetual government bonds); and second, the series relied on to represent yields on bonds of business companies (i.e., the Actuaries’ Investment Index) has reflected only the “current” (“running”) yield, i.e., the ratio of the nominal (“coupon”) interest rates on the securities to their prices2 which, as explained below, is only a portion of the variation in their total yield. Data available for the United States suggest a third factor which may be more important than either of these, viz., that the cyclical variations in the long-term rates paid by borrowers are substantially in excess of those in the series for average yields, which are based on a sample of outstanding, established (“seasoned”) bonds. Analysis of this third factor will be the chief concern of this paper.

Concentration of attention on yields on consols has been misleading because of the large decline in the price of such a security caused by, say, a rise of one percentage point in its yield. When the yield rises from 4 per cent to 5 per cent, the price of the security drops by one fifth. Knowledge of this relationship induces investors to refuse to buy consols in recession periods if an attempt is made to push the yield below, say, 4 per cent.3 The 4 per cent level may therefore be a minimum to which consol yields can be pushed in time of recession. But perpetual bonds are not representative of the debt issues of industrial countries. The prices of the 14-year to 20-year range of maturities, which includes most of the issues of industrial borrowers, fall only by half or five eighths as much as the prices of consols for a 1 per cent increase in yield. This means that investors would be willing to buy these bonds even after their yield had fallen below the 4 per cent level. If investors were willing to accept the risk of just as great a price decline for industrial bonds as for consols, they would be willing to buy the industrials as long as yields were no more than 2 per cent (rather than 1 per cent) below the levels foreseen. This suggests that the cyclical variability of interest rates on bonds actually issued by business is (almost) twice as great as the variability of the yield series usually considered—yields on consols. The possibilities for stabilizing investment are therefore much greater than observation of the limited variability of consol yields suggests.

Use of the current yield to represent yields on industrial debentures understates the cyclical amplitude of the movements in the yield from these bonds, because it makes no allowance for the additional return to the lender when market rates are high and the average outstanding bond is selling below par: viz., the profit to be received on redemption of the bond at a price of 100, which is reflected in a gradual rise in the bond’s price as it moves closer to its redemption date. Conversely, when market rates fall to low levels and the price of the average outstanding bond rises above par, the observed decline in the issue’s current yield is reinforced by the pending loss that will be realized when the bond is redeemed at par.

The variability of yields (and hence prices) on existing bonds is of chief concern to the financial wealth holder, whose actions may prevent bond yields from dropping far during recession periods. But the stabilizing effects of monetary policy can be exerted most effectively through its influence on borrowers; and the would-be borrower is influenced by the amplitude of variation in the interest rate that he pays, which is the rate on new bond issues. The underrepresentation of the cyclical variability in long-term bond yields that is due to the citation of the average yield on existing (“seasoned”) rather than newly issued bonds may be deduced from data on bond issues in the United States. It will be shown in this study that the amplitude of variation of the yield on new issues is systematically ½-¾ percentage point wider than the amplitude of the conventional series of yields on seasoned long-term bonds, on which economists’ opinions have been based. Thus, in June and July 1957, when interest rates were at a peak, the yields on all new issues of long-term public utility bonds exceeded the current yields on seasoned bonds by between 0.48 and 0.98 percentage point. The weighted average excess was 0.94 percentage point in June and 0.69 percentage point in July.

Some recognition of the wider amplitude of yields from new issues has developed since the middle of the 1950’s, but even that recognition has been limited by a view that the wider oscillations observed were, to a great extent, reflections of the rapidity of change in long-term rates; this implies that if economic conditions made it necessary to stabilize rates at high levels, the excess yield paid by new borrowers would shrink to a small amount, and the cycle-stabilizing benefits from the wider amplitude of yields on new issues would almost disappear. Although some of the observed widening of amplitude is probably a transitory reflection of expected changes in yields, it will be shown that a major part of the excess yield observed is permanent, a reflection of the difference in characteristics between the new bond issues and those older issues which happen to be chosen to represent the long-term interest rate.4

Charts 1 and 2 illustrate the relationship over time between interest rates paid by long-term borrowers and the reported rates usually taken to represent long-term interest rates in the United States. They show, for Grade A and Grade Aa public utility bonds, the yields on new 30-year issues and the comparable Moody’s average yields on outstanding bond issues.5 Three periods of high interest rates are covered—1953, 1957, and 1959. In each period the yield on new issues was much in excess of the reported yields on seasoned issues, while during the adjacent low interest periods the new issue yield was approximately the same as the seasoned yield.6

Chart 1.
Chart 1.
Chart 1.

Medium-Grade Bonds: Comparison of Interest Rates on Newly Issued and Seasoned Bonds in United States, 1947–601

Citation: IMF Staff Papers 1962, 001; 10.5089/9781451955972.024.A005

1 Grade A public utility issues. Data are daily for 1947–56 and monthly for 1957–60.2 Yields on newly issued bonds minus yields on seasoned bonds.
Chart 2.
Chart 2.
Chart 2.

High-Grade Bonds: Comparison of Interest Rates on Newly Issued and Seasoned Bonds in United States, 1947–601

Citation: IMF Staff Papers 1962, 001; 10.5089/9781451955972.024.A005

1 Grade Aa public utility issues. Data are daily for 1947–56 and monthly for 1957–60.2 Yields on newly issued bonds minus yields on seasoned bonds.

Reasons for High Flexibility of Interest Rates on New Bond Issues

It is important to know how surely the flexibility of yields on new issues of long-term bonds, observed in the past, can be expected in the future, and whether the extra flexibility would exist for rate variations going beyond the observed range of interest variation. The answers to these questions can be approached by investigating the causes of the differential in the flexibility of yields on new issues relative to those on seasoned issues.

The corporate bond market in the United States places several billion dollars of new corporate bond issues during a year. The chief buyers of the higher grade issues are professional, sophisticated investors: life insurance companies, pension funds for industrial company employees, and similar bodies. Neither wealthy individuals nor business enterprises subject to the full (52 per cent) corporate income tax rate are significant factors in the market. The very large financial institutions, including the biggest life insurance companies, participate in the market for new issues but tend to be excluded from the smaller-scale market that exists for older, seasoned bonds. Moreover, since the Second World War, the large insurance companies and pension funds have been concentrating on purchases of nonmarketable, “privately placed” bond issues, which bypass the delays and expenses of “public” security issues.

Since a major part of institutions’ portfolios is presently made up of these nonmarketable bonds, the volume of market transactions in seasoned bond issues may by now have seriously diminished. However, the rapidity of growth of the pension funds and the existence of many smaller life insurance companies, which are less able to handle direct placements of nonmarketable bonds, but which are interested in maximum return on their portfolio investments, probably ensures that there is still sufficient activity in the market for seasoned bonds to permit meaningful comparisons of the yields on new and on seasoned issues.7

Four factors share the responsibility for the greater flexibility of yields on new bond issues: (1) the pressure of a heavy volume of new issues on the market for bonds, (2) an inverse relationship between willingness to sell seasoned bonds and the level of interest rates, (3) greater sensitivity on the part of issuing houses than of holders or buyers of seasoned bonds to the possibility of further rises in interest rates during periods of tight money, and (4) the lesser risk when interest rates are abnormally high of premature redemption and the greater chance of capital gain on bonds selling below par than on new bonds issued at par.8 Since Charts 1 and 2 show that there is no discrepancy between new issue and seasoned yields when interest rates are “low”9 but increasing discrepancies as rates become “high,” the operation of these four factors can be conveniently studied in conditions of high rates.

Pressure of heavy volume of new issues on the market for bonds

It is commonly argued that high interest rates are accompanied by tightness in the capital markets: interest rates are high because the demand for long-term funds has a tendency to become larger than the available supply. In this situation, it is easier to find buyers for small quantities of a bond issue than it is to find permanent lodgment in investment portfolios for the large blocks of bonds that must be moved out of the market within a short time after a major bond issue is first made. For this reason, high interest rates tend to be accompanied by yields in the new issues market that are higher than those available in the small-scale “seasoned” bond market.

This problem of distributing new flotations is often cited in financial circles. A typical presentation of the problem is the following close paraphrase of an advisory publication addressed to bond buyers: “In recent weeks the large number of bond flotations has caused the various issuers to compete for the more-or-less limited supply of loanable funds in the hands of investing institutions by offering interest yields that are abnormally high relative to yields in the seasoned market.” This form of argument is incomplete because it fails to explain why the competition is among new issues only, i.e., why (after some slight rise in new issue yields above seasoned yields) bond buyers do not shift away from the market for seasoned bonds; and why holders of seasoned bonds do not attempt to liquidate their holdings and to acquire instead new issues on which the interest rate is higher. Without such an explanation, it can only be assumed that a rise in yields on new issues would depress the prices of seasoned issues to the point where yields on seasoned issues rose (practically) as much as the yields on new issues. Congestion of the market might account for a small differential (say, 0.1 percentage point), but it fails to explain the large observed differentials.

Relationship between willingness to sell seasoned bonds and level of interest rates

The financial community’s chief explanation for the failure of yields on seasoned issues to rise as much as the yields on new issues appears to be the following. At times of “high” interest rates, the “coupon” rates of interest on bonds in the bond yield averages are below the current market rate since most of the seasoned bonds were issued in periods when lower interest rates prevailed. Such seasoned bonds will be salable only at a discount, and a shift from seasoned issues to the higher-coupon new issues would involve the realization of a capital loss equal to this discount. But those who hold nonspeculative, high-grade corporate bonds are usually more concerned with avoiding the acknowledgment of capital losses than with obtaining comparatively small additions to their rates of return on capital. Now a delay in selling the seasoned security will cause the capital loss to be wiped out if interest rates fall again, or, at worst, holding the bond to maturity will assure its redemption at par. Consequently, although the attitude is not justifiable rationally, investors may refrain from liquidating their holdings even when they could transfer their funds into new issues offering rates of interest higher by, say, 0.75 percentage point.

It follows from this argument that, at times, some seasoned bond issues may not be offered for sale when interest rates are high. Others are offered only at prices so high that the rate of return (“maturity yield”) obtainable would be abnormally low relative to that obtainable in the new issues market. The combination of these factors tends to overprice seasoned bonds (to the point where few or no sales can be made) and thus to make the bond yields implied by the price quotations low relative to the true cost of long-term money, viz., the interest rate being paid in the new issues market. Specifically, this combination of narrow markets and nominal bond price or yield quotations is likely to cause a downward bias in the interest-rate series usually cited—the averages of yields on several seasoned issues as reported, e.g., by Moody’s Investors Service or by Standard and Poor.10

The higher the level of interest rates, the greater would be the discount below par at which seasoned bonds would sell. It follows that the willingness to offer seasoned issues at all, and the willingness to offer them at realistically low prices, should be smaller, the higher that interest rates become. In other words, any unwillingness to realize capital losses causes excesses of new issue yields over seasoned bond yields to be greater as the general level of long-term rates rises. This relationship should persist even when interest rates move above earlier peaks. And because the capital-loss factor is a function of the level of rates rather than of the rate of change in that level, this kind of spread between the yields on seasoned and on new issues should persist when interest rates have reached a plateau.

The strength of this “capital-loss aversion factor” is questionable. It depends on certain implicit assumptions, which can be brought to light by a diagram (Diagram 1).

If it is assumed for purposes of exposition that new and seasoned issues are economically identical, buyers of new issues should be willing to switch completely to seasoned issues as soon as the yield on new issues falls below that on seasoned issues. Similarly, those planning to buy seasoned issues would shift completely to new issues as soon as the yield on new issues rose above that on seasoned issues. However, it must be admitted that when the yield on new issues was, say, a quarter percentage point above that on seasoned issues, there would still be some demand for the latter because of the special requirements of particular bondholders. The behavior of the demand for seasoned issues is represented by curve D in Diagram 1.

Analogously with the demand, the supply of seasoned issues becomes very large as soon as the yield on new issues rises slightly above that on seasoned issues; yet for various reasons there will be some supply of seasoned issues even though their yield is a quarter percentage point higher than the yield on new issues. The behavior of the supply of seasoned issues is represented by curve S0. The two curves must intersect at an interest rate for seasoned issues which differs very little from the rate on new issues (compare intersection a and the zero-difference line).11

The introduction of a restriction on the willingness of holders of seasoned bonds to switch to new issues (such as would be provided by an aversion to realizing capital losses) causes the S curve to shift upward, to Si; this means that a larger interest-rate advantage on new issues would be required before a large amount of switching would be considered worthwhile by holders of seasoned bonds. However, the aversion to the realization of loss is either irrational (the capital loss being just as real whether the depreciated bond is retained in the portfolio or is replaced by another bond having the same market price but yielding more) or grounded on considerations of public relations (unwillingness to report losses). Many bondholders will not be deterred by irrational considerations from pursuing the maximization of profits; and, for many, public relations considerations will be irrelevant. Life insurance companies are said to be in this latter group. Moreover, a small portion of existing portfolios will probably have been acquired during earlier periods of high interest rates at prices that were below par, and the sales of such issues would not entail much (if any) capital loss; indeed, some sales might provide capital gains under the cover of which other holdings could be sold at a loss. In addition, for individuals, trust funds, and commercial banks, the tax laws may operate as an inducement to take losses. The banks are known to have engaged very actively in “tax swapping” of their government bond portfolios during the 1957 tight money episode, switching from one security to another of substantially the same character. (The capital losses realized were fully deductible from their taxable income, whereas only one half of the subsequent capital gains—when the similar security purchased was redeemed or sold at par—was counted in taxable income.)12

From the preceding discussion, it follows that an appreciable part of the supply offered in the absence of a deterrent to capital losses would still be offered without any extra inducements despite the existence of such a deterrent; this is illustrated in Diagram 1, where curve S1 intersects the vertical axis almost as far down as curve S0 did. The consequence of this is that shifting the supply curve raises its point of intersection with the unchanged demand curve only very little—from a to a’. In other words, the excess of the yield on new issues over that on seasoned issues which aversion to losses can cause should be very small. On the assumptions introduced above, the yield differential in favor of new issues created by aversion to losses—the distance a a’—would be far less than ¼ percentage point and probably much less than ⅛ percentage point.13

The prevalent opinion that aversion to losses holds yields on seasoned issues significantly below those on new issues is dependent on an implicit assumption that the uneconomic, specially motivated desire for transactions in seasoned bonds (the steep segments at the left of the D and S curves) is felt more urgently by the demanders of seasoned issues than by the suppliers, i.e., the demand for seasoned issues at yields below that obtainable on new issues is much larger than the amount of seasoned issues which would be offered if new issue yields were equally below seasoned yields. (In this situation, curve D would cross the zero line well to the right of where S crosses it, and the intersection between S1 and D would occur at a point well above a’.)

The strength of the reasons that would make suppliers and demanders willing to make transactions at these economically disadvantageous prices is impossible to quantify. However, it appears probable that, on balance, these transactions will be reflected in the diagram by an intersection which would be the reverse of that required to produce a relative rise in the yield on new issues. Those demanding seasoned long-term bonds have the easily purchased new issues as practically perfect substitutes for seasoned issues. Relatively few would be willing to buy seasoned issues at lower yields. (One reason for such a purchase might be the need to correct an imbalance in the maturity distribution of the portfolio that was due to an unexpected call for redemption of bonds already owned, at a time when new issues of the appropriate maturity happened to be unavailable.) On the other hand, holders of bonds may frequently be anxious to sell at uneconomic prices because outside considerations—the expiration of a trust, the rise of individual or trust income to a point at which tax-exempt bonds become preferable, or a decision by an investment company to switch from bonds to stocks—require that portfolios be liquidated. (Purchases to establish new portfolios are, of course, free from any such restriction to the seasoned market.) Changes in the quality ranking of outstanding issues may alter their desirability for given portfolios; this can lead to some sales of such issues, but bond buyers (including the one that has to replace his unsuitable holding) are unaffected; their criteria of choice between new and seasoned bond issues of the same quality class are unaltered.

From these considerations it follows that the effects of an aversion to capital losses on the differential between the yields on new and seasoned issues should be extremely small. S0 may pass through the horizontal segment of D, and the leftward shift of S1 as sales at a loss become necessary may therefore hold the S1-D intersection quite close to the horizontal segment. In any case, the departure from symmetry between D and S in the diagram above should be small enough to preclude yield differentials as large as ⅛ percentage point. Because the motives behind a large part of the transactions actually realized are so heterogeneous, it is possible, of course, that the actual relationship will vary erratically, and that at times a deviation in the popularly supposed direction will occur. However, there seems no justification for expecting the deviations to be more frequent in that direction than in the opposite one.

The true explanation of discrepancies between the yields on new issues and on seasoned issues thus remains to be discovered.

Extra yields offered on new issues to protect issuers against risk of rise in interest rate

A new bond issue in the United States is normally purchased from the issuing company by an underwriting syndicate, which counts on reselling the issue to investors for a price which is less than 2 per cent above that paid to the company. If interest rates should rise while an issue is being sold to the public, the sales price would have to be reduced; even a small reduction could easily make the underwriting operation unprofitable. To avoid this danger, bond underwriters are said, when they sense any danger of a rise in interest rates, to require that new issues be offered at exceptionally favorable yields. This ensures that the issue will be oversubscribed or fully sold in the first few hours it is available, or at least that, if conditions should prove unfavorable, the issue will remain salable at the stated price despite any intervening rise in market interest rates.

Yields on seasoned bonds will also be pushed up by bondholders’ and traders’ expectations of rising rates and falling bond prices. However, the reasoning just described implicitly assumes that expectations of rate increases will have less influence on the seasoned bond market. And it is quite possible that underwriters of new issues (and the borrowers they serve) are more concerned with these risks than are existing bondholders or potential buyers of seasoned bonds. If so, the yields fixed on new issues can be raised above those on seasoned issues. Normally, the attempt to create such discrepancies between yields would be frustrated by a switching of demand from the seasoned to the new issues. In the situation considered here, however, such diversions of demand are impossible because the underwriters are obliged by law to sell the entire issue at its initial offering price, and this means that excess demand will be handled simply by rationing the fixed quantity of bonds. Holders and potential buyers of seasoned bonds are therefore unable to divert any more demand away from seasoned bonds, to take advantage of the new issue’s inflated yield, than they would have done if the two yields had been almost identical. Thus it is possible for the seasoned yield to be uninfluenced by any extra (insurance premium) yield that is offered on new issues.14

It is important to have some idea of the size of this form of augmentation of yields on new issues because such an addition would not vary in any simple manner with the level of interest rates. The extent of the need for protection against the risk of rising interest rates depends not on the current level of rates but on the chance of a rise in rates during the near future. Charts 1 and 2 appear to show that the maximum excess of yields on new issues over those on seasoned issues developed while rates were rising toward their peak early in 1953 and in 1957, and that there were only very small excesses when rates were dropping after the middle of 1953 or early in 1958. If this evidence should be taken as demonstrating the predominance of the interest-rate risk factor in the observed excess of yields on new issues over those on seasoned issues, it would follow that the greater part of the extra cyclical amplitude observed in yields on new issues would not endure if the peak of the cycle should last over an extended period of time; if it were known that the boom had leveled off at its peak and, in consequence, the fear of further rises in interest rates were dispelled, then the observed rise in the rate of interest actually paid by borrowers would no longer be much in excess of the rise in yields on seasoned bonds.15 As the conviction grew (e.g., during a prolonged period of controlled inflationary pressure) that the existing level of yields on seasoned issues was the maximum, interest rates on new issues would fall back toward the seasoned rates. However, the presence of two periods in which the spread between yields stayed high but yields on seasoned issues were slightly declining or were constant— the first four months of 1957, when it was thought that the cyclical downturn might be starting, and the last few months of 1958—suggests that expectations of rate movements are far from dominating the yield differential (except perhaps in the unimportant case of falling yields).16

Without knowing what investment bankers are thinking when they fix the price and yield of a new bond issue, it is impossible to say just how large may be the extra interest yield offered on new issues for protection against the risk of interest rate rises. It ought not, however, to be sufficient to account for as much as half of the three-quarter percentage point excess of new-issue over seasoned yields prevailing when rates are high (Charts 1 and 2). In view of the facts that a favorably priced bond issue should be sold out well within a few days,17 that long-term rates do have a narrow range of variation in contrast to short-term rates, and that movements within this range are normally gradual, it would seem that ample protection would be offered by excess yields of 0.25 percentage point (e.g., 4.25 per cent instead of the 4.00 per cent which would suffice for salability at the existing level of interest rates). While the most volatile of the long-term utility yields—the rate on new issues—has risen during a full month period by as much as ½ per cent, the yield cushion made necessary by that range of variation would be only half as great, for the decline in price associated with the rise in the given issue’s yield would independently enhance that issue’s desirability (see below, p. 126). Moreover, underwriters bidding for an issue do not need to insist on so much protection. An amount of protection that is just sufficient would insure that the issue would be sold out in far less than a month’s time, so that protection against the maximum one-month rise would be entirely unnecessary. And insurance against all possible declines in a bond’s price below the level fixed at the time of issue is expensive for the borrowing company. Competition among investment bankers for bonds to issue should tend to prevent them from insisting on yields on new issues that are high enough to provide complete protection.18

The fact that the differential between the yields on new and seasoned issues varies with a fair amount of regularity as a function of the seasoned interest rate provides empirical evidence in support of this conclusion. If the expected direction of change in interest rates were the chief factor in the differential, the differential should fluctuate erratically and independently of the current level of the seasoned interest rate. Since this is generally not the case—given allowance for differences in quality and salability among new issues and for errors in issuers’ judgment-—underwriters’ expectations on changes in yields ought not to be the major factor.

Alternatively, the link between the differential and the yield on seasoned issues may be due to the existence of some important element in the differential which varies with the level of current interest rates. For example, one large underwriter has stated that, within the charge made for underwriters’ services, the allowance to cover part of the risk of rate increases is greater both when rates are rising and when they are high, since underwriters (irrationally) feel that the risk of increase is relatively great when the level of rates is already high.19

In summary, the surplus yield on new issues which is required by the underwriting syndicate as protection against declines in a bond’s sale price during the period of sale may be responsible for, say, one third of the observed excess of yields on new issues over those on seasoned bonds. The entirety of this segment of the extra interest charge can be relied upon to strengthen monetary policy only where the policy is designed to moderate swings in business cycles having brief peaks. Where, instead, the restraint of persistent inflationary pressure by high but stable interest rates is involved, perhaps half of the excess yield attributable to underwriters’ caution will cease to be available as a contribution to monetary policy.

Excess yields on new issues as compensation for risk of call and smaller chance of capital gain

The greater part of the observed difference between the yields on new issues and seasoned issues at times of high interest rates can be shown to be dependent only on the general level of interest rates. From the viewpoint of the buyer of bonds, all issues made at high interest rates are actually a different kind of security from issues made in periods of low interest rates. This difference is one which exists even among bonds that are already seasoned, have the same maturity date and the same quality, and are debts of the same company.

When long-term rates are considered abnormally high, it is to be expected that newly issued long-term bonds can be held for only a few years at most; when interest rates decline, a small rise in the prices of these bonds will cause them to be “called” for redemption out of funds acquired through bond issues floated at then-prevailing lower interest rates.20 Thus, almost all of the bonds issued at the high interest rates prevailing in the spring of 1953 were refunded at lower interest rates in 1954 and 1955, and large refundings occurred after the slight decline in interest rates in 1949.21 Purchasers of new bond issues at a time of high rates thus foresee finding themselves with abnormally large supplies of funds to be invested at just those times when the interest which can be earned is abnormally low. This problem is of acute concern to life insurance companies, since the charges for insurance which they can offer in the competition for customers depend on the average rate of interest they can earn on investments.

With old, low-coupon bonds, this risk of decline in interest earnings is avoided, for the discount below par at which such bonds sell at times of high interest rates provides a margin of safety: because their price is free to rise, the effective yield on such bonds will be able to fall with market rates, which means that a call for redemption cannot become profitable for the debtor.

Because low-coupon bonds have this advantage, investors are willing to pay a little more for them, thus accepting lower yields. And since in recent years most of the high-coupon bonds have been new issues, this preference for low-coupon bonds is probably responsible for the greater part of the observed excess of average yields on new issues over the average yields on seasoned bonds. In the middle and late 1930’s, on the other hand, when interest rates were declining continuously, the high-coupon issues were the seasoned ones and the low-coupon issues were the new ones. As a result, new issues were generally made at interest rates below the average rates customarily cited. Thus the average yield on seasoned issues may have understated the amplitude of variation in the long-term interest rate actually paid by borrowers during the Depression period of falling rates, just as it has the amplitude of rate increases in prosperity.

Abnormally high levels of bond yields, such as those at the end of 1959, tend to attract into the bond market investors with speculative leanings. They too prefer the low-coupon, seasoned bonds, but not solely for the reason just cited. Seasoned bonds selling at a discount below par offer the possibility of sizable capital gains, should interest rates drop back to a more normal level. For example, for every decrease of ⅟10 percentage point in the yield on seasoned bonds (e.g., from 4.50 per cent to 4.40 per cent), the price of 25–30 year bonds rises by 1⅔ per cent. A drop of one-half percentage point in interest rates would thus create a capital gain of 8 per cent. And, provided the price ceiling fixed by the call price was not reached first, a fall of 1 percentage point in the market rate would produce a one-sixth rise in the price of a low-coupon bond. For those who expect interest rates to fall in two years, the 8 per cent and 16 per cent gains would be equivalent to enlargements by 4 and 8 percentage points, respectively, in stated interest yields.22

The preceding can be looked at as merely a second dimension in the supply price of loanable funds. The higher the price received, the greater the supply of long-term funds. The familiar measure for this price—the rate of interest—should be used only if the other “non-price” terms of the transaction are constant. Where the call-risk/capital-gains aspect also changes as the interest rate changes, a two-dimensional price must be used. Curves are presented below (Charts 3, 4, and 5, and Diagram 2) which show the combinations of interest yield and call protection that elicit the same supply of loanable funds. These may be considered indifference or “iso-price” curves.

Chart 3.
Chart 3.

Bond Yields and Capital Gain Potentials in United States, End of November 19561

Citation: IMF Staff Papers 1962, 001; 10.5089/9781451955972.024.A005

130-year Aa utility bonds issued late 1955-late 1956. Meanings of symbols are as follows: Unseasoned (recently issued) bonds. Numbers indicate month and day of issue in 1956.● Less recent issues. Except for two issues in 1955, which are so labeled, numbers indicate month of issue in 1956.◯ Bonds in Moody’s Aa utility bond yield average. Figures unreliable; either from secondary source or the required “asked” price, which is not available, is assumed to be 2 per cent above the “bid” price.← Moody’s average less 0.05 per cent adjustment to “asked” price basis.↙ See text footnote 30.
Chart 4.
Chart 4.

Bond Yields and Capital Gain Potentials in United States, End of December 19561

Citation: IMF Staff Papers 1962, 001; 10.5089/9781451955972.024.A005

1 For description of bonds on which chart is based and for meanings of symbols, see Chart 3, footnote 1.
Chart 5.
Chart 5.

Bond Yields and Capital Gain Potentials in United States, End of December 19591

Citation: IMF Staff Papers 1962, 001; 10.5089/9781451955972.024.A005

130-year Aa utility bonds issued 1955–59 and bonds in Moody’s average. Meanings of symbols are as follows: Unseasoned (recently issued) bonds. Numbers indicate month and day of issue in 1959.● Less recent issues. Numbers indicate month of issue in 1959. Dots that are not dated represent issues recommended by Moody’s Bond Survey in late 1959 and said to be available in good quantity.◯ Bonds in Moody’s Aa utility bond yield average.← Moody’s average less 0.05 per cent adjustment to “asked” price basis.↙ See text footnote 30.2 Yields higher than issue yields, overcompensation for yield at issue being too low.3 Also among the issues recommended by Moody’s Bond Survey.

Indirect call-risk/capital-gains factor

In addition to its direct responsibility for excess yields on new issues, the call-risk/capital-gains factor has indirect responsibility for a part of the extra yield on new issues which underwriters require as assurance of the issue’s salability. Since the call-risk factor accounts for most of the extra volatility of a yield on new issues relative to that on seasoned issues, it must also account for part of the underwriter’s risk that new issues will be made unsalable by unforeseen increases in interest rates. Consequently, the presence of the call-risk factor must cause underwriters to enlarge the yields fixed on new issues. As will be explained later (pp. 140-42), the direct effects of the call-risk factor on the variability of yields on new issues can be estimated as a 50 per cent increase over the variability of those on seasoned issues. If a parallel enlargement of the safety margin in the yield which underwriters require is assumed, the estimates of the direct effects of the call-risk factor on yield set out below must be enlarged by perhaps 110 percentage point. (Since the underwriter’s safety margin is partly dependent on the expected change in rates rather than on the level of rates, this indirect call-risk/capital-gains effect on yields on new issues would diminish if interest rates should stabilize at their peak.)

Empirical verification of call-risk/capital-gains factor

Because bond buyers vary greatly in their concern with the risk of call and the possibilities of capital gain, it is not possible to determine a priori what the yield differential should be. However, its size can be estimated empirically. For each of the 30-year Aa public utility bonds issued during November 1955-November 1956, the interest yield to maturity and an index of the bond’s protection against call and potential capital gain are shown in Charts 3 and 4. The index is the excess of the bond’s call price over its current market price; for the greater this excess, the greater would be the fall in interest rates necessary to raise the market price to the level of the call price. Chart 3 shows these data at the end of November 1956 and Chart 4 shows them at the end of December 1956. When allowance is made for the differences among bonds’ characteristics, which lead to different valuations by the market, and for the degree of imperfection present in the seasoned bond market, the relationship between the call-risk/capital-gains factor and the interest yield is seen to be strikingly good. The greater the difference between call price and market price, the lower is the interest yield to maturity.

Chart 5 shows the correlation, when rates were at a cyclical peak at the end of 1959, between the yield and the excess of call price over market price for a wide range of issues: all suitable issues of 1959, issues in the Moody average of late 1959, several issues in good supply recommended at the end of 1959 by Moody’s Investors Service, and a few of the issues shown in Table 1 for which reliable quotations could still be found. The 1959 correlation is almost as good as those of late 1956 and confirms the persistence of the relationship. Further confirmation is provided by data for 1957 and 1958 shown in Table 1.

Table 1.

United States: Adjustment Over Time of Excess Yields on New Issues, End of Month

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These yields are based on averages of bid and asked prices, but they are shown here after deduction of 0.05 percentage point to approximate the asked-price basis on which the yields of the individual bonds listed here are computed.

This issue provides a reliable base because it is a very actively traded, large ($70 million) issue of a well-known utility company (Consolidated Edison of New York). The yield on this issue was always quite close to the Moody’s average, except in June 1958. Since the yields on the other bonds available followed this issue rather than the Moody’s average between May and June 1958, there is reason to suspect that the composition of the latter was changed. (At some time in 1958, between the regular spring and autumn publication dates, two substitutions occurred which raised the average coupon rate of the ten Moody bonds by 0.2 per cent.)

Spurious contributions to relationship between yield and protection from risk of calls

Financial specialists frequently explain the cyclical variation in the difference between the yields on new and seasoned bonds as due chiefly to friction and imperfections in the bond market. There are two branches of this explanation. According to one, new issues tend to be made at excessive yields, and the process of “seasoning,” which is reflected in a decline in their yields to the yields on seasoned bonds, takes time. In the periods of rising rates being considered here, this would mean that the correlation observed between yield and opportunity for capital gain at any given time is merely one between the yield and the length of time the bonds have been outstanding. Interest rates were rising over most of the period from November 1955 to the middle of 1957; in that situation, the bonds showing both the smallest excess of call price over market price and the highest yields should be the ones most recently issued. But with the passage of time, the part of the new issue’s yield needed to get large blocks lodged in the portfolios of long-term investors and the further amount of yield provided to protect the underwriter should decline and disappear. If the time required is as much as, say, nine months, then the apparent correlation between the call-risk/capital-gains factor and interest yield shown in the charts is (in large part, at least) a spurious one.

The other explanation given by financial specialists reverses the preceding analysis and explains the cyclical variations in the spread between the yields on new and on seasoned issues by the inactivity and sluggishness of the market for the latter. The real capital market is said to be that for new issues, and the market for seasoned issues a backwater whose eddies tardily reflect the movements in the new issues market.23 This explanation also would make the correlation between yield and the call-risk/capital-gains factor a spurious one.

Examination of the patterns of bond yields at a single time and the relative movements in yields over time fails to support either of these explanations.

In actuality, it appears that most of the yield differential associated with newness disappears after a few months. Certainly, the halved circles on Charts 3 and 4 show that issues which have been on the market for only a month or two have yields which are significantly higher than would be consistent with the relationship between yields and possible capital gains indicated by less recently issued bonds. The month of issue is indicated by the number—or the first number— attached to each observation in Charts 3 and 4. But the yields of issues which have been available for more than, say, two months do conform to the yield/capital-gain relationship indicated by the less recent issues. And among the less recent issues themselves, the possibility of a time correlation is likewise small, for some of the earlier of the issues show higher yields (and suitably lower capital gain prospects) than issues appearing more recently. Thus, a bond issued in April 1956 shows a higher yield and lower capital gain than one issue of May, two of June, and two of July.

To extend the observations to include bonds selling at greater discounts than those issued since October 1955, the bonds included in Moody’s Aa public utilities series have been added to Charts 3 and 4 (open circles). In Chart 3, these additional points, in combination with those representing the lower-priced bonds among those issued in 1955/56, demonstrate a flattening of the yield/capital-gain relationships; when the call-risk/capital-gains factor is as great as, say, 12 per cent of a bond’s par price, additions to the scope for gain and protection against call enhance the attractiveness of the bond by rapidly diminishing degrees. (This is easily explained by the fact that a reduction in interest rates sufficient to push the price of an issue standing at a discount up to its call price becomes extremely unlikely once the price of the issue is, say, 16 per cent below the call price.)

Further indications that the yield pattern is not just a matter of delayed adjustment are provided by Chart 5, which demonstrates a similar ranking among a variety of 1957 and 1959 issues.

This evidence that seasoning does occur very rapidly is further corroborated by a comparison, presented in Table 1, of the movement over time of the excess of the yields on recent issues over those on seasoned, low-coupon issues. The table demonstrates that the seasoning process is completed in a very few months and that a ranking of bonds by yield is established and maintained which almost exactly duplicates the ranking by coupon rate. (The coupon-rate ranking is roughly equivalent to a ranking by difference between call price and market price, since the lower the coupon the lower will be the price required to produce a given yield maturity.) A lapse of about two months from the date of issue appears sufficient to complete the seasoning process, i.e., to bring the yield on the new issue into a relationship with the basic yield corresponding to the relationship already established for older bonds with similar coupon rates.24

The columns of Table 1 provide strong confirmation of the view that yield differentials reflect chiefly the amount of protection against call. (To simplify comparison, the dates of roughly equal levels of market interest rates are grouped together, with an intervening point of high interest rates shown separately in the last column.) Apart from the low-coupon issues, for which differences in coupon rate should affect yield by only small amounts, at every date the yields rise consistently as the coupon rate rises from one level to the next. Moreover, the relationship is quite stable (due allowance being made for the imperfections and the divergent concerns that must be felt in the bond market). Thus on five of the six dates at which the yields on seasoned issues were about equal, the yields of the two 3⅝ per cent issues were no more than 0.03 percentage point apart, while the divergence on the sixth date was only 0.10 point. On the three dates for which the three 4¼ per cent issues are available, the divergence was no greater than 0.09 point.

The maintenance of proper ranking for the yields of the two highest coupon bonds, the 4½ per cent and 4¾ per cent issues, when market rates were low, is less valuable evidence of the influence of the call-risk/capital-gains factor under investigation. They represent an extreme case of that factor—when the price of a high-coupon bond has risen close to the ceiling set by the bond’s call price. At that stage, the call-risk/capital-gains consideration becomes overwhelming and should be conceded even by those who deny its validity for lower-priced bonds.25 To show that the same ranking of yields is established when these bonds are selling well below call price, the last column of Table 1 presents the yield differentials established when interest rates were at a cyclical peak and the prices of high-coupon bonds were relatively depressed. Essentially the same rankings are found, although two issues were out of line. (The one that was far out of line, the 3¾ per cent issue, was on the verge of disappearing from active trading and need not be given much weight.)

The financiers’ alternative explanation for the greater amplitude of variation in yields on new issues—an alleged slow reaction of market prices of the inactively-traded seasoned issues to conditions on the new issues market—is made very dubious by several considerations. As shown in Charts 1 and 2, even though the amplitude of variation of the yields on seasoned bonds is smaller than that on new issues, the yields on the two types of bond are closely synchronized in regard to the timing of peaks, troughs, and major discontinuous changes. Moreover, the available evidence shows an adequately large volume of transactions in seasoned bonds by professional investors (such as pension funds and the smaller life insurance companies for whom the market’s size is adequate), so that the prices of many of the larger issues of seasoned bonds can be assumed to reflect fully the conditions on the broader, new-issue bond market.26 And accurate, reliable prices of seasoned bonds could emerge even if only a very minor fraction of the outstanding amount were sold during a given year. This is made plausible (although not a certainty) by the homogeneity of the various bond issues and of investors’ interests in them; these homogeneities should make most holders unwilling to make transactions at the market’s equilibrium price but to make very large transactions at prices that diverge appreciably from that equilibrium (cf. the long horizontal ranges of the seasoned bond demand and supply curves in Diagram 1, above). Finally, the case against the explanation relying on a belated reaction can be completed by invoking the much more plausible call-risk/capital-gains explanation—an explanation which is necessary to account for the yield-price relationships among bonds that are only a few months old and still traded very actively on the New York Stock Exchange.27

The impression that seasoned bond yields move sluggishly may be due in part to observation of the yields on bonds that are issued when interest rates are high or moderately high. A small decline of interest rates below their peak is sufficient to push the price of high-coupon bonds to the ceiling fixed by the call price. With prices prevented from rising further, the yield on the high-coupon bond can no longer follow the decline in the yield on seasoned (and new issue) bonds. In the same way, after a somewhat greater decline in general interest rates, the yield on bonds issued when rates were moderately high becomes immobilized and ceases to follow the downward movement of yields on low-coupon, low-priced, seasoned bonds and new issues.

In short, sluggishness of price movements in the market for seasoned issues is unacceptable as an explanation for the lesser volatility of the seasoned bond yield averages.

Quantification of call-risk/capital-gains factor

With the validity of inferences from Charts 3, 4, and 5 now established, the quantitative contribution of the call-risk/capital-gains factor to the yield differential can be estimated. The scatters of points on Charts 3 and 4 indicate that the newest issues should have yielded— after the temporary excess yield had disappeared—about 4.05 per cent in November and December 1956. These figures compare with Moody’s yields on seasoned issues of 3.77 per cent and 3.81 per cent, respectively.28 The call-risk/capital-gains factor should therefore be responsible for an excess yield on new issues of at least one-quarter percentage point. Similarly, Chart 5 indicates an excess yield for high-coupon issues of at least one-third percentage point (5.05 per cent minus 4.70 per cent) at the end of 1959. These estimates of the excess are raised to over one-third percentage point and nearly one-half percentage point, respectively, by the addition of an allowance for the indirect effect of call risk aversion on the size of the temporary excess yield on new issues (see above, p. 128).

The data in Table 1 confirm the inference that a quarter to three-tenths percentage point of the discrepancy between the yields on new and on seasoned issues at times of high interest rates is explainable by the direct call-risk/capital-gains factor. The seasoned issue which is comparable to the new issue as far as call-risk/capital-gains factors are concerned is one selling at about its issue price. Since issue prices are commonly about 1 percentage point above par, the yield to maturity on such an issue can be more precisely fixed at about 0.06 percentage point below its coupon rate.29 The procedure for the calculation of the call-risk factor is therefore as follows: Interpolation between two issues selling just above and just below 101 provides an indication of the coupon rate on a bond which would sell at 101. From this coupon rate, the yield on a corresponding new issue is calculated by deducting 0.06 per cent. A comparison of this yield with that on the basic, low-coupon bond shows the excess yield which the call-risk factor makes necessary for new issues.

In December 1956, the yield on the 4⅛ per cent issue (4.01 per cent) exceeded that on the “basic” 3⅜ per cent issue (3.85 per cent) by 0.16 per cent. Since the yield of 4.01 per cent was 0.11 percentage point below the coupon rate, the 4⅛ per cent issue, allowing for loss on maturity, sold for about 102. The adjacent issue, a 3⅞ per cent issue, yielded 3.99 per cent, and therefore sold for 98. The yield interpolated between these two issues is 4.00 per cent (a bond priced at 101 that yields 4 per cent). This 4 per cent yield exceeded the yield on the “basic” bond by about 0.15 percentage point and the (adjusted) Moody’s yield by about 0.20 percentage point, and it follows that the direct call-risk/capital-gains factor accounted, according to these data, for two fifths of the ½ per cent excess yield observed on new issues at the end of 1956 (Chart 2).

By the same reasoning, in March 1957 a 4 per cent issue yielding just under 4 per cent—one-quarter percentage point above the (adjusted) Moody’s average—would have represented the direct call-risk/capital-gains element in the excess yield on new issues.

In May 1957, the direct call-risk/capital-gains factor is represented by an excess of 0.37 percentage point over the (adjusted) Moody’s yield which would have been given by a 4¼ per cent coupon issue yielding 4.2 per cent.

The reduction in long-term rates due to the recession brought the adjusted Moody’s yield to 3.62 per cent in February 1958. By interpolation it can be shown that the appropriate yield on new issues was just below 3.7 per cent. This implies a coupon rate of about 3¾ per cent for a bond selling at 1 per cent over par. In that situation, no excess yield on new issues over yield on seasoned bonds was required by the direct call-risk/capital-gains factor; this conforms to expectations, for at that time there was not much likelihood of a further decline in interest rates. (The same indications are given by the June 1958 data.) These indications are confirmed by the facts: yields on new issues were little in excess of the published yields on seasoned bonds.

At the end of August 1957, when interest rates were at a cyclical peak, the 4½ per cent issue was yielding just 4½ per cent. It follows that an issue selling for 101 would have had to have a coupon rate slightly above 4½ per cent and would have yielded about 4.55 per cent—a yield 0.30 per cent above the (adjusted) Moody’s yield.

Persistence of call-risk/capital-gains contribution to yield differential

It is difficult to say whether the call-risk/capital-gains factor would lead to a greater yield differential at a time when interest rates were higher than they were late in 1959. The outcome would seem to be dependent on how much the minimum level of interest rates expected in a recession moves up as the peak level of rates being experienced during periods of prosperity becomes higher. If maximum rates are higher in future periods of peak prosperity than they have been in the past, but expectations about the minimum level of rates in recession are unchanged, then the spread between the yields on new and seasoned issues should be further enlarged. But if the rise in maximum rates is paralleled by expectations of minimum rates in the next recession that exceed those in past recessions, then the yield spread should not be enlarged. Such a change in expectations appears to explain the fact that the spread between the yields that occurred when rates reached a new peak late in 1959 and early in 1960 was not wider than the spread found at the lower peak of 1957. The experience of continuing increases in prices during the 1958 recession, and the rapid upturn of long-term interest rates after the middle of 1958, made general an impression that creeping inflation would continue, so that the levels of bond yields appropriate to each phase of the business cycle had to be higher than had been previously expected.

The relationships are described in Diagram 2—a schematic representation of Charts 3, 4, and 5. (Straight lines are used for simplicity.)

With the recession minima of interest rates expected to be at the level of ob, those bonds selling oe below their call prices when interest rates are at their peaks can be assumed to be free of risk of being called, and also to offer the maximum possibility of capital gains. Bonds selling at prices that increasingly approach the call price have increasing risks of call and decreasing prospects of capital gains. The curve representing the relationship between yield and protection against call (excess of call price over market price) therefore rises to the left of point d. A fall in rates to the intermediate level would place at point c the bond previously found at d. The risks of call would be equally as great as before, and bonds having lesser amounts of call protection would still have to provide higher yields to maturity; the yield curve therefore would continue to slope upward to the left of c. The bond found at points d and c is found at b when rates reach their cyclical minimum.30 It is selling no higher than its call price and hence is not worth refunding. Bonds that sell at increasingly large excesses above call price are in increasing jeopardy and show very rapid rises in yield, with the yield to maturity on issues made at a time of peak rates still very little below its peak31 (compare the bonds represented in the last two rows of Table 1). If expectations had been revised and the intermediate rate had been considered to be the cyclical low point, the yield curve would have fallen from ch to cg, i.e., would have become level to the left of c (as far as the y axis). A rise in the expected average level of rates, with the expected amplitude of cyclical variation unchanged, is provided for simply by an upward vertical shift of the three curves. A rise in the expected amplitude with no increase in the rate at the trough of the cycle is provided for by an upward and rightward shift of the curve through d, with the locus of point d on the curve moving along the line bcd, together with a parallel but smaller shift of the curve through c.

Given the straight lines of Diagram 2 and no change in the expected minimum level of interest rates, the excess yield on new issues should vary in direct proportion to the excess of the yield on seasoned issues over the minimum level of the latter. In other words, the excess yield on new issues would rise by a constant fraction of the rise in seasoned yields.32

Two factors thus far ignored will have opposite effects on the size of the excess yield as the maximum level of rates rises. Given the rule that the call price should exceed the issue price by approximately the equivalent of one year’s interest (represented by a requirement that new issues should lie on the line af), the enlargement of the yield on new issues should be accompanied by a corresponding rise in the call premium; this combination may attract significant amounts of demand from short-term investors who are willing to gamble on a decline in rates that will cause the bond to be called within not much over one year, for in that situation very high short-term interest rates would be earned. The pressure of this kind of demand will tend to restrict the rise in excess yields on new issues. Acting in the other direction is the factor of dispersion of expectations about the lowness of rates in the next recession. The lowest curve in Diagram 2 is at best a band rather than a line. As the price paid for loanable funds rises, it can be assumed that hitherto unwilling suppliers are being attracted. Among the marginal suppliers of loanable funds are those who foresee a decline in rates to a point below b in Diagram 2. For such lenders, the yield on a high-coupon bond which matches that on low-coupon issues must be higher than indicated by the cyclical peak curve in the diagram. In other words, inflection point d is found further to the right on the horizontal range of the curve through d. Therefore the sloped segment to the left of d would intersect the y axis at a higher level than shown in Diagram 2. It follows that the acceptable yield on new issues would be further above the yield on seasoned issues than indicated in Diagram 2. (A similar modification is required for the intermediate curve through c, although the rightward displacement of inflection point c is smaller than that of point d.)

Since the net effect of these two opposing factors is unknown, Diagram 2 can be retained as a useful first approximation. Whatever the net balance of effects may be, it is obvious that raising the cyclical peak of interest rates means raising the excess of the yield on new issues over that on seasoned issues, if the rate at the trough of the cycle is expected to remain unchanged or to increase by a smaller amount. Charts 3, 4, and 5 indicate that for each additional percentage point of rise in yield on seasoned bonds, yields on new issues would rise by at least 1½ percentage points (see footnote 32).

In concentrating on the call-risk/capital-gains aspects of the differences between the yields on new and seasoned issues, the preceding discussion has disregarded the factors explaining the rest of the excess yield on new issues. The latter are easily introduced into Diagram 2. When interest rates are high, new issues are offered at prices that place the bond on line af but above the yield curve for the high-coupon seasoned issues. After each issue is sold out, market forces will push up its price so that it will move downward and to the left of line af, tracing a path parallel to bcd (which represents the arithmetical relationship between change in price and associated change in yield). This movement continues until the issue reaches the yield curve (at, e.g., the leftward end of the cycle peak curve passing through d). At this point, yield on the issue reflects the pure call-risk/capital-gains factor. At the time of issue, the excess of the yield offered beyond that required by the curve through d represents the protection to the issuer and the extra inducement needed for quick marketing of a large issue.


At present, more and more new issues preclude calls for redemption during at least the first five years after issue; new issues may therefore be taking on something of the call-risk/capital-gains characteristics of low-coupon bonds. A continuation or enlargement of the wide variation in long-term rates over the business cycle experienced in recent years may lead lenders to force the extension of the practice of restricting the right to call. (It is said that the life insurance companies, which acquire a major part of the debt issues of manufacturing and mining companies by direct negotiation, already require protection against calls for more than five years—often for as long as ten years.) This tendency might be expected to reduce the range of cyclical variation of new issue yields toward that of seasoned yields.

Such a development would not detract from the significance of the preceding analysis, however. As a first approximation, any advantage to the lender from nonrefundability is simply a mirror image of the corresponding disadvantage to the borrower; hence, the reduction in the interest rate that the lender is willing to accept in exchange for the restriction on calls is, from the borrower’s point of view, merely a compensation for the rise in the borrowing-cost-equivalent which the restriction connotes (i.e., the loss of the opportunity to reduce the interest rate paid by calling the issue and reborrowing when rates are lower). Thus, effective borrowing “costs” are, in a first approximation, not reduced.

From another point of view, unless the issue is noncallable for most of its life, the cyclical variability of the yields on bonds which have restricted calling rights should always be significantly greater than that of yields on low-coupon, seasoned issues. In fact, it has been observed that a five-year restriction on calls results in very little reduction in the yield below that on fully callable new issues.33 It is not surprising that five years of prohibition against calls would be little valued by the market. If a decline in long-term rates more than sufficient to drive current new issues to their call prices is expected in 12 months, the price of a bond with a prohibition on calling within five years after issue can be expected to rise above that level by only as much as four-year bonds rise. (This is because the bond can be redeemed at its call price after four more years and will be so redeemed if interest rates are low at that time.) But the price of a bond that is to be redeemed in four years cannot rise very much above the redemption price, and that redemption price is likely to be 1 per cent below the price receivable if callable bonds are held. The opportunity to receive for four years even 1 per cent higher interest rates (higher than could be earned if the bond had been callable and were called 12 months after issue and the proceeds had to be placed in, say, four-year securities at the then low interest rates), minus the 1 percentage point lower call premium, could raise the value of the bond by 2¼ per cent. That much extra scope for price increases can be considered equivalent to an addition of 2¼ percentage points to the capital gain possibilities—i.e., to an additional 2¼ per cent excess of call price over market price on the callable bond. Charts 3, 4, and 5 suggest that this would connote a reduction of something like a 17 percentage point reduction in required yields.

It might be thought that unrestricted callability makes even the high yields required on callable bonds in prosperous times ineffectual as a deterrent to borrowing. If a return to lower, more normal rates can be expected in 12 months, the high-cost issue can be called and paid off with the proceeds of a new, low-yield issue. Pointing out how high the cost of callable new issues can rise would seem a meaningless exercise. This view is indefensible. It disregards the need to pay the call premium of one year’s interest on the bond, say, 5 per cent over the issue price, plus the costs of the second new issue, all of which would raise the effective interest cost on borrowing today, rather than 12 months hence, from the apparent new issue rate of, say, 5¼ per cent to as much as 11½ per cent. This must be a powerful inducement to postponement of investments that are dependent on the issue of long-term debt.


On pense souvent que la faible amplitude des variations des taux d’intérêts à long-terme durant toute la période du cycle économique limite les possibilités de contrôler une économie par la politique du taux d’intérêt. Cette faible amplitude est due en partie à la résistance des acheteurs aux réductions de taux en période de récession, car le prix des obligations achetées lorsque les taux sont faibles, baissera lorsque les taux remonteront. Toutefois, elle a souvent été surestimée en raison de l’utilisation de critères défectueux. Les renseignements disponibles pour les Etats-Unis montrent que le taux effectivement payé sur les obligations à long terme nouvellement émises a enregistré des variations en pourcentage supérieures de 1/2 à 1 point à celles de la moyenne du rendement des obligations types en circulation.

La plus grande variation des rendements des nouvelles obligations est-elle le résultat de conditions passagères ou traduit-elle un rapport systématique? Des variations plus fortes dans le rendement des obligations en circulation auraient-elles pour conséquences des variations proportionnellement accrues pour les nouvelles émissions? Les réponses à ces questions résident dans les facteurs qui provoquent cette variabilité supplémentaire. Pour les financiers, la nécessité d’avoir un rendement d’intérêt exceptionnellement favorable s’explique essentiellement par deux facteurs — la difficulté en période de contraction monétaire d’écouler de grandes quantités d’un nouveau titre et la croyance des organismes garantissant l’emprunt que l’insuffisance de liquidité, peut entraîner un relèvement des taux d’intérêts qui rendraient la nouvelle émission implaçable sans un tel rendement supplémentaire.

Alternativement, les augmentations du rendement des obligations en circulation sont, dit-on, restreintes par le peu d’empressement des détenteurs de vendre à perte lorsque les taux augmentent, ou par le retard avec lequel le marché étroit et peu animé des obligations en circulation reflète les changements de conditions du marché principal des nouvelles émissions.

Dans cette étude, il s’avère que les facteurs mis en avant par les financiers expliquent en partie la variabilité supplémentaire des rendements des nouvelles obligations, que les autres facteurs sont sans importance, et que le facteur essentiel réside dans le fait que les nouvelles émissions offertes lorsque les taux sont supérieurs à la moyenne cyclique, ne représentent pas la même valeur économique que les obligations en circulation émises lorsque les taux étaient au niveau de la moyenne cyclique ou à un niveau inférieur. En période de resserrement monétaire, ces dernières se vendent à des prix très inférieurs à leur prix d’émission ou de remboursement et par conséquent peuvent augmenter en valeur lorsque les taux d’intérêts diminuent, alors que les obligations émises lorsque les taux sont élevés sont déjà proches du prix auquel elles peuvent être rachetées par l’emprunteur immédiatement ou quelques années après. Les obligations émises lorsque les taux sont élevés doivent par conséquent offrir des taux d’intérêts supérieurs à celui de l’obligation moyenne en circulation.


El margen reducido de las fluctuaciones en las tasas de interés a largo plazo durante el ciclo económico, se considera con frecuencia como un obstáculo a la posibilidad de controlar una economía mediante la política de las tasas de interés. Ese margen reducido se debe, en parte, a la resistencia de los compradores a aceptar reducciones en la tasa de interés durante periodos de baja actividad económica, porque la cotización de los bonos comprados cuando las tasas de interés son bajas, será menor en cuanto estas suban nuevamente. No obstante, la estrechez de ese margen ha sido con frecuencia sobreestimada, debido a que se ha usado un criterio deficiente. Los datos disponibles sobre los Estados Unidos muestran, que la fluctuación de la tasa de interés efectivamente pagada sobre bonos a largo plazo de nueva emisión, ha excedido en 1/2 a 1 punto porcentual la de los promedios de rendimiento de los bonos en circulación, que generalmente se toman en consideración.

¿Es la mayor amplitud de rendimiento de los bonos de nueva emisión producto de una situación transitoria, o refleja acaso una relación sistemática? ¿Es que mayores fluctuaciones en el rendimiento de los bonos existentes, indicarían talvez variaciones proporcionalmente mayores para nuevas emisiones? Las respuestas a estas preguntas pueden hallarse en los motivos que ocasionan esa variabilidad adicional. En los círculos financieros se da mayor preponderancia a la necesidad de ofrecer un rendimiento de interés excepcionalmente alto, debido a dos factores — la dificultad en negociar grandes lotes de un valor de nueva emisión en épocas de escasez de dinero y la creencia de que esa escasez puede conducir al aumento de las tasas de interés, que harían invendible la nueva emisión, a no ser por ese rendimiento suplementario.

Alternativamente, el aumento de los rendimientos de los bonos ya en circulación, se dice estar restringido por la renuencia de los tenedores de bonos a vender con un margen de pérdida cuando suben los intereses, o por la lentitud con que los cambios de las condiciones de los grandes mercados de nuevas emisiones se reflejan en los flojos mercados de escala limitada de los bonos ya en circulación.

En este estudio se llega a la conclusión que los factores aducidos por los círculos financieros son, en efecto, responsables, pero sólo en parte, de esa variabilidad adicional en el rendimiento de nuevas emisiones, que los otros factores son insignificantes, y que el factor principal es que las nuevas emisiones ofrecidas cuando las tasas de interés se encuentran por encima de sus promedios cíclicos, son económicamente inferiores a aquellas que se emitieron cuando las tasas de interés se encontraban al nivel del promedio cíclico o a un nivel más bajo. Estas últimas se venden a precios mucho más bajos que su valor nominal o de rescate, en épocas de escasez de dinero y, por lo tanto, pueden subir de precio cuando los tipos de interés bajan, mientras que los bonos emitidos cuando las tasas de interés son altas, se encuentran ya casi al nivel de precios a que podrían redimirse por el prestatario, ya sea de inmediato o dentro del lapso de unos pocos años. Los bonos emitidos cuando las tasas de interés están altas, deben, por tanto, ofrecer tipos de interés más altos que el del promedio de los bonos en circulación.

a new publication by the fund

Central Banking Legislation

A collection of Central Bank, Monetary and Banking Laws

Statutes and related materials selected and annotated by

Hans Aufricht

Preface by Per Jacobsson

Any person who has had occasion to use Central Bank or Monetary Laws has undoubtedly experienced difficulties in obtaining versions of those laws that are both comprehensive and up to date. If the laws are officially published in a language other than English, many people may also have the problem of finding translations.

The present volume attempts to meet these difficulties. It presents, in English, the complete texts of Central Banking and Monetary Laws of 21 countries; it gives summaries of general banking laws and selected provisions of these laws which are of special significance in the relationship of the Central Bank to the banking sector.

The laws reproduced have been selected mainly for the following reasons: (1) They represent both the oldest (United Kingdom) and the most recent types of central bank and monetary legislation (e.g., Ceylon, Costa Rica, Guatemala, Philippines) ; (2) they represent laws couched in very broad terms (e.g., Union of South Africa), laws which regulate central bank functions and powers in considerable detail (e.g., Ceylon, Guatemala, Philippines), and laws which fall between these two groups (e.g., Burma, Honduras) ; (3) they reflect the central banking and monetary regimes of countries at different levels of economic development.

The laws of these 21 countries constitute a representative cross section of both the traditional and the most recent attitudes on the legal techniques employed for regulating money and credit. These legal techniques are of interest not only to lawyers and economists in general, but also to all persons currently engaged in the administration of individual central banking organizations; to the historian of central banking, who will find here significant material; to the general student of central banking; and to legislators and technicians charged with revising present central bank regimes or with setting up such institutions in countries where none have existed.

For convenience of comparison, the laws included in this volume have been arranged in three groups:

Group I: Australia, Canada, Rhodesia and Nyasaland, Union of South Africa, United Kingdom;

Group II: Burma, Ceylon, India, Indonesia, Japan, Korea, Pakistan, Philippines;

Group III: Costa Rica, Cuba, Dominican Republic, El Salvador, Guatemala, Honduras, Mexico, Nicaragua.

Pp. xxii + 1012


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Mr. White, economist in the Finance Division, received his undergraduate and graduate training at Harvard University. He has contributed articles to a number of economic journals.


R. F. Harrod, Towards a Dynamic Economics (London, 1948), p. 120, and Richard Goode and Eugene A. Birnbaum, “The Relation Between Long-Term and Short-Term Interest Rates in the United States,” Staff Papers, Vol. VII (1959–60), pp. 224-43.


See description of the series in U.K. Annual Abstract of Statistics, 1959.


Harrod, loc. cit., and James Tobin, “Monetary Policy and the Public Debt,” Review of Economics and Statistics, Vol. XXX (1953), p. 126.

Those doubting the possibility of wider cyclical variations in interest rates often doubt their desirability as well, on the grounds that (a) wider variations would entail higher average rates to counteract the additional risks to bondholders of wider price movements; (b) in prosperous times very high rates tend to be inflationary rather than deflationary owing to their effect on government expenditures for debt service and the rise in living costs associated with higher mortgage rates and business costs of production.

It may be briefly noted that the second of these two points disregards the usually cited demand-deflating effect of high interest rates. The first point is not relevant to the widening of the range of variation discussed in this paper. It refers to the amplitude of variations in the yields on seasoned bonds, and to the consequential risk of capital loss to the holders of such bonds, bought when interest rates were depressed, should these rates subsequently rise. The amplitude of variations considered in this paper is the larger one which is found in a different series, viz., the interest rates paid by borrowers on successive new issues.


It may be noted that the cyclical variability of the short-term bank loan rate is also understated by the customary U.S. statistics. The unique U.S. banking tradition, that of all loans received a fraction must be left on deposit with the lending bank (roughly 10 per cent in times of easy money and 20 per cent when credit is tight), caused the 1½ percentage point rise in bank charges reported between autumn 1958 and autumn 1959 to be an effective increase of rates of 2.36 percentage points. (In addition to understating the effective variations in banks’ interest rates, disregard of this consideration has led to overstatement of the cyclical variation in the effective money supply.)


Through 1955 the data are Moody’s series of weekly averages of the published daily interest rates, i.e., the average yield on ten Grade A and Grade Aa quality seasoned public utility bonds having 25-35 years to maturity. After 1955 the data are the tabulations in Moody’s Bond Survey of monthly average yields on seasoned issues and of the weighted average of yields on new issues during the months. Bonds having any of the characteristics of shares are excluded. However, bonds with restrictions on the time of call for redemption (which first appeared in late 1956) are included in the averages of yields on new issues.


This paper is based on public utility securities rather than on industrial bonds because the former provide a larger number of fairly homogeneous new issues. Similarly, while Baa bonds might be more representative of industrial issues than A or Aa bonds, the yields on Baa bonds are too diverse for efficient comparisons between different issues and over time. Hence Aa bonds are given chief attention. Industrial bonds do, however, appear to show the same yield patterns as Aa bonds.

A major part of corporations’ bond financing is through “privately placed” issues for which no yield statistics are available. However, since the chief market for such security issues comprises the same investors who dominate the new public issues market (life insurance companies, etc.), it is to be expected that the interest costs paid by borrowers would be about the same for new private issues as for new public issues (see E. R. Carey, Direct Placement of Corporate Securities, Boston, 1951, pp. 109-10, and George J. Leness and others, New Money for Business: Techniques of Long-Term Corporate Financing, New York, 1956, pp. 91-92). Hence the exclusion of data on private placement yields does not limit the generality of the present investigation.

Data recently made available for Germany show, even more clearly than the U.S. data, conformity in the timing of changes between yields on seasoned issues and new issues but a much greater amplitude of variation in yields on new issues. During 1959–60, yields on new issues rose 1½ percentage points—over twice the rise in yields on outstanding issues; and in a subsequent reversal, a portion of these movements was retraced. The yield differences associated with a given level of yield on seasoned issues appeared to be the same whether rates were rising, falling or stable. (See Monthly Report of the Deutsche Bundesbank, January 1962, p. 14.)


Sources of information on the U.S. bond market are given in footnotes 13, 22, 25, and 26 (pp. 121, 128, 135, and 136).


A fifth explanation often given is that the comparative inactivity of the seasoned bond market causes seasoned bond prices to adjust to prices in the new issues market only after some delay. This explanation is highly questionable, and in any case it would, like the fourth explanation in the text, constitute no barrier to the maintenance of high yields on new issues. Therefore, it is dealt with only as a part of the test of the validity of the fourth explanation.


This is not a logically necessary relationship. All that is logically necessary is a smaller amplitude of variation for yields on seasoned bonds. In fact, in the 1930’s, when interest rates on bonds were very low, yields on new issues tended to be below the average yields reported for seasoned bonds; see David Durand and W. J. Winn, Basic Yields of Bonds, 1926–1947 (National Bureau of Economic Research, New York, 1947), pp. 38-39. As will be made clear below, in part this was the consequence of the fact that bond yields had been declining continuously during the 1930’s.


The erratic and biased character of the yields on seasoned bonds has led one financial writer to condemn the popular series of average bond yields and to propose that some average of yields on new issues be used in place of high-grade (seasoned) bond yield averages to represent “the” interest rate; see R. F. Murray, “What Yield Do You Use?” Security Analysts Journal, August 1955, p. 15. But despite the fact that some series for yields on new issues have become available in the last few years, economic and financial analysis has continued in general to be based on averages of yields of seasoned issues.


The close proximity of the D and S0 curves along most of their length is correct only on the assumption that seasoned bonds can be bought and sold without commission. In fact, the buyer of the seasoned bond may pay a ¼ per cent commission (above the “asked” price), which is equivalent to a decline of 0.01 per cent in the yield and can be ignored. The seller pays the same commission and, in addition, has usually to accept a “bid” rather than an “asked” price, so that he typically receives a price 1½-2 per cent below the asked price. This means, since the yield differential is computed on the basis of the seasoned issues’ asked price, that the seller of seasoned bonds requires an extra yield of 0.09-0.12 percentage point on new issues before he will switch to them. To allow for this qualification, the horizontal portion of S0 can be drawn above the zero level by 110 per cent. The actual yield on seasoned issues (asked price basis) would, of course, rise by less than this: the point of intersection between the demand curve and the supply curve would rise by less than the latter rises, showing an insignificant increase, such as 0.05 per cent. Moreover, as will be described later, the buyers of seasoned bonds, for whom the asked price is relevant, may dominate in the determination of the price equilibrium. In that case, the excess of the yield on new issues over that on seasoned issues can be treated as if unaffected by the cost of selling seasoned issues.


The strength of the taxation inducements to take losses should not be overestimated; the banks’ holdings of long-term corporate securities are relatively small, and individuals and their trust funds can deduct the full amount of capital losses from income only to the extent of $1,000 in a given year (plus a carryforward of $5,000 more into the next five years) and must include any capital losses on other kinds of assets. On the other hand, as shown in Diagram 1, actual transactions in seasoned bonds will probably involve only a very small part of the outstanding holdings of those who are prepared to participate in the seasoned market. Bondholders who have no aversion to losses should therefore account for a major part of the potential market that would be activated by a small change in the yield differential.

Instances of search for maximum income regardless of capital losses realized are cited in L. S. Wehrle, “Life Insurance Investment—The Experience of Four Companies,” Yale Economic Essays, Spring 1961, p. 129.


These conclusions might be challenged on the ground that a prolonged period of high rates, say, three years, might be expected to use up the infinitely elastic range of the supply of low-coupon bonds (the flat segment of curve S1 in Diagram 1 just above and to the right of a’ becoming shortened and finally disappearing). This would cause a’ to rise appreciably. That is, however, unlikely to occur for two reasons. In the first place, the available evidence suggests an annual volume of transactions in public utility and telephone bonds, excluding the large proportion of transactions that are between brokers, of only about 10 per cent of the outstanding total. (A tabulation of non-new-issue bond sales in the over-the-counter market during three months of 1949 showed a total of $514 million sold; outstanding bonds were about $13½ billion. See Irwin Friend and others, The Over-The-Counter Securities Markets, New York, 1958, p. 122.) Since a major part of the final sales included in this figure will have been made for special reasons by those who were averse to the realization of capital losses (cf. the leftward steeply-rising segment of curve S1 in Diagram 1), it follows that relatively little will have come from the infinitely elastic segment of the supply curve representing those bondholders who are not averse to realizing capital losses. Even if only, say, 15 per cent of the outstanding bonds are in the hands of those not averse to realizing capital losses, several years of high rates would have to pass before the infinitely elastic segment of the supply curve could disappear. In the second place, the infinitely elastic range tends to reconstitute itself, for insofar as net sales to others at a loss occur, the purchasers will be holding bonds which they acquired at a discount and hence will face no capital-loss obstacle, or only a small one, to the resale of the securities later in the high interest rate period.


This conclusion requires two qualifications: First, this sort of rise in yields on new issues should have some psychological effect on yields in the seasoned market, especially if the higher yield is long continued. Second, some extra funds may be diverted from the seasoned market by the extra yield; this can occur insofar as the large savings institutions—which buy most of the new issues but are excluded from the seasoned market because the minimum size of a transaction which it is efficient for them to undertake is too large for that market—are the ones to lose out by the rationing of new issues, while buyers normally operating in the seasoned market are able to obtain a part of the new issue under the rationing arrangements and thereby divert some funds from the seasoned market.


There is one further reason for concern over the importance of the underwriter’s interest-rate risk factor in the observed yield spread. That factor is probably much weaker for the bond issues of manufacturing companies than for the public utility issues used here to represent the entire bond market. This is so because public utility issues must normally be awarded to underwriters by competitive bidding on the day before the date of issue, whereas industrial companies usually have continuing arrangements with a single underwriter which give the latter time to test the market, adjust the yield offered, and secure enough customers in advance of the issue.


If, in fact, yields on new issues did decline more quickly than yields on seasoned issues, this would be highly advantageous, for it would mean that antideflationary policies take effect more rapidly than commonly thought by those who worry about the difficulty of lowering long-term interest rates.


Leness, op. cit., p. 148, reports that a successful public utility issue “normally” sells out in a few hours.


If the yield on a new issue should prove inadequate, the price of the bond may have to decline until it is at a point where a more than “adequate” yield is offered. Although this consideration justifies enlargement of the extra yield on new issues, it ought to leave the total allowance for interest risk within the ¼ percentage point range. Raising the yield on a 25-30 year issue by ¼ per cent would increase the borrower’s interest payments by an amount that has a present value equal to 3½-4 per cent of the value of the issue.


See Leness, op. cit., p. 113. This variability in underwriters’ charges is significant in another connection also: it increases the cyclical flexibility of long-term borrowing costs somewhat beyond what is shown by the data for yields on new issues.


Refunding is profitable for the debtor company if the interest rate at which it can reborrow is lower than the interest rate it ceases to pay when it redeems an existing debt. But if the price of the high-coupon bond issue were free to rise as market rates fell, the situation would be the same as that of an investment in the bonds of other firms that were issued at a time of high interest rates. As market interest rates decline, the prices of these other bonds will rise so that their yields remain equal to market rates. And it is pointless to borrow at the market rate to purchase bonds which yield no more than the market rate. In the case under consideration, however, the price at which the company can buy back its own bonds cannot rise above the “call price” (usually the original issuing price plus one year’s interest), and large savings in interest payments do become possible.


Moody’s Bond Survey, January 21, 1957, p. 747.


The differential income tax treatment of the interest yield to maturity on bonds selling close to, or well below, par could logically explain an important part of the observed spread between yields on seasoned and new bond issues, and require the existence of such a spread even if interest rates were at their cyclical minimum. Individuals paying high rates of income tax should strongly prefer bonds selling at a discount because that part of their yield to maturity which represents the rise in their prices toward par (or the redemption price) will be taxed at the low capital gains tax rate. In practice, the uncertainty of receiving the favored tax treatment on the low-priced bonds in all years (the capital gains tax applying only to the excess of the year’s gains over any losses realized), and the unimportance in the seasoned bond market of those paying high tax rates, make this an unimportant explanation for the yield differential. The seasoned bond market is dominated by pension funds and other tax-exempt or partially tax-exempt institutions. Even when yields are at cyclical peaks, there is still “only a scattering of individual investor interest” in the high-grade bond market. (See D. M. Kelly, “Basic Structure of the Corporate Bond Market,” Commercial and Financial Chronicle, July 20, 1961, p. 24.) Wealthy individuals who pay very high taxes on current income are not interested in the capital gains tax advantages of bonds standing at a discount because fully tax-exempt state and local bonds offer much higher net-of-tax yields.

Individuals might be attracted by the higher levels of peak interest rates offered on the medium-grade bonds that industrial firms commonly issue. The present discussion, based on high-grade bonds, is nevertheless conclusive, for it establishes that an important discrepancy in yield exists even in the absence of strong tax considerations.


See, for example, A. F. Brimmer, “Credit Conditions and Price Determination in the Corporate Bond Market,” Journal of Finance, September 1960, pp. 365-66.


For the two issues of January 1957 shown at the bottom of the table, a relative reduction in yield of 110 per cent apparently remained after two months of seasoning had occurred (cf. declines in excess yields between March and May 1957). This may reflect a peculiarity of the 3⅜ per cent series used as a norm, for practically all of the other, more fully seasoned, issues experienced parallel reductions in excess yield. And when the average of Moody’s series is taken as a norm in place of the 3⅜ per cent issue, these reductions disappear. The 3⅜ per cent issue may therefore have experienced an erratic movement at the end of May 1957.


Thus David Durand and W. J. Winn (op. cit.) made the point in 1947 that the seasoned bonds then available for bond yield averages sold above par and therefore had to have unrepresentatively high yields. But for conditions like those of today they merely said: “If interest rates ever rise substantially so that high-grade bonds are selling at less than par, the coupon-yield relationship may present new problems for analysis” (ibid., p. 40, note 6).

The present paper, which was originally prepared in 1957 for use within the International Monetary Fund, was brought to date for publication. Apart from the peripheral indications contained in the Durand-Winn footnote, no support by the financial community, written or oral, for the call-risk/capital-gains factor was discovered in the course of preparation. Subsequently, however, a description of the bond market by an officer of a leading bond house was published in which the seasoned bond market (apparently a very active one) was described as dominated by sophisticated institutional investors; private individuals were considered a negligible factor; and the call-risk factor was mentioned as an explanation of the difference between the yields on new issues and on low-coupon seasoned issues. The differential caused by this factor was said to be very small, however, because bond buyers could not well judge the prospects for long-term interest rates and because of the prevalence of prolonged call restrictions in the large proportion of new issues that were privately placed with institutional investors, especially life insurance companies. Aversion to capital loss was not mentioned as a factor in the yield differential. See D. M. Kelly, op. cit., pp. 24-25.


R. F. Murray, loc. cit., criticized the customary yield averages partly on the ground that the new issues market is insulated from the market for seasoned issues, being dominated by the large life insurance companies, pension funds, etc., which must deal in such large blocks that they would disorganize prices on the market for seasoned issues (which must deal chiefly in “odd lot” amounts of any given bond). Although the large institutions which dominate the new issues market are excluded from the seasoned market, the dominant groups in the latter (small insurance companies, small pension funds, and banks and trust funds, as well as individuals) can move with complete freedom between the two markets. (See Investment Bankers Association of America, Fundamentals of Investment Banking, New York, 1949, p. 762, for verification of the fact that the smaller life insurance companies operate easily on the “seasoned” market; see M. Hamberg and others, Characteristics of Transactions in Over-The-Counter Markets, Philadelphia, 1953, pp. 51-55 and 76, and Irwin Friend, Activity on the Over the Counter Market, Philadelphia, 1951, p. 27, on the domination of non-new-issue bond transactions by the various financial institutions and the comparatively large size of their purchases and sales.)

An officer of one large life insurance company, who agreed that large units could not buy and sell efficiently on the market for seasoned bonds, nevertheless considered that insurance companies as a whole annually “purchase and sell tremendous amounts” of seasoned bonds. That these do not reflect specially arranged, irregular acts is indicated by the fact that the company normally does not know the identity of the seller or buyer of the bonds transferred. (See R. B. Patrick, “Management of the Life Insurance Investment Portfolio,” in Investment of Life Insurance Funds, David McCahan, ed., Philadelphia, 1953, pp. 64-65.) Some more recent statistics are available to support this view. Voluntary sales of corporate bonds from portfolios, plus (probably very minor) sales of municipal bonds and corporate stocks, which “typically arise as investment officers face particular opportunities to switch their holdings to improve yield, strengthen quality, or broaden diversification of the portfolio,” are estimated to have totaled the large amounts of $700 million in 1957 and $800 million in 1958 (K. M. Wright, “Gross Flows of Funds Through Life Insurance Companies,” Journal of Finance, May 1960, p. 156). Since this estimate is an extrapolation of data on the larger companies (which have difficulty in making open market sales of seasoned securities) to represent all companies, it presumably understates total sales of seasoned securities but may correctly represent total sales of seasoned corporate bonds.


The frequency and reliability of bond price quotations tend to decline as the bond ages and, apparently, disappears from circulation. This suggests a tendency toward a diminishing frequency of over-the-counter transactions. Even though the stock exchange is only a secondary market place for (nonspeculative) corporate bonds, the published data on transactions show that six months after an issue has appeared transactions are still quite large; and that lapse of time is sufficient to establish the coupon rate-yield relationship.


These yields are Moody’s figures adjusted to an “asked” price basis from the reported average of “bid” and “asked” prices. The spread between the two prices is typically 1½-2 per cent; Moody’s bond prices were normally, therefore, ¾-l per cent below those used in this study. The lower prices mean that Moody’s yields as reported are about 0.05 percentage point higher than those used here.


This is derived from the arithmetical relationship between market price and yield to maturity. A rise in the bond’s price to 1 per cent above par reduces the yield to maturity in two ways: it reduces the ratio of the interest payment to the amount invested by 1 per cent, and at the time of redemption (at the par price of 100) it subjects the investor to a 1 per cent capital loss. The 1 per cent reduction in a 4 per cent interest payment costs slightly less than 0.04 percentage point, and the 1 per cent capital loss incurred after, say, 30 years is equivalent to less than a one-thirtieth or 0.03 percentage point reduction in annual interest receipts. The two elements together cost a little over 0.06 per cent.


The path traced by bcd represents the arithmetical relationship between a bond’s price and its yield to maturity. The slope of bcd is given by the fact that for 30-year bonds a 1 per cent change in price causes an opposite change of 0.06 percentage point in yield to maturity. In Charts 3, 4, and 5 a long arrow is drawn to indicate this slope.


Represented by a steep slope (not shown in Diagram 2) in the yield curve to the left of the origin.


When the yield on seasoned issues rises from ob to og, the yield on new issues rises (in a first approximation) by the additional amount gh. The ratio of this extra rise gh to the rise bg in the basic yield is easily seen to equal the ratio (sign disregarded) of the slope of the rising segment of the yield curve, ch, to the slope of the line bcd. The first slope is approximated by the slope of straight lines fitted to the rising segments of the yield curves in Charts 3, 4, and 5. The slope of bcd is determined arithmetically (an 0.06 percentage point rise in yield for each 1 per cent decline in price).

With the ratio of the two slopes called a, the seasoned yield is, the cyclical minimum yield on seasoned issues is.min., and the estimated yield on new issues in, the above relationship may be represented algebraically as follows:


Inspection of Charts 3, 4, and 5 suggests that a, the ratio of extra change in the yield on new issues to the accompanying change in the yield on seasoned issues, may be in the range of ½ to ¾.

The above formula ignores the temporary additions to new issue yields caused by difficulties of marketing and fears of intervening rises in interest rates. A slight exaggeration of the permanent rise in yields on new issues is created by the simplifying assumption that the new issue will be found at h on curve ch rather than at the intersection of that curve with line af (see next paragraph of text).


W. J. Winn and A. W. Hess, Jr., “The Value of the Call Privilege,” Journal of Finance, May 1959, p. 189. A representative of the Securities and Exchange Commission (which discourages the electric power companies it supervises from accepting call restrictions) considered that five-year call restrictions had no significant effect on yields; see J. A. Pines, “Discussion,” Journal of Finance, May 1959, p. 219.

IMF Staff papers: Volume 9 No. 1
Author: International Monetary Fund. Research Dept.