THE ECONOMICS OF THE PRIVATE MARKET
Maturity and Prepayment Penalties
According to their maturity distributions, commercial and industrial bank loans tend to have relatively short maturities, private placements tend to have intermediate- to long-term maturities, and public bonds have the highest proportion of long maturities. In 1989, the median bank loan had a maturity of just over three months, and the mean maturity was around nine months (charts 8 and 9). 18 Almost 80 percent of loans had maturities of less than one year. When weighted by loan size, two-thirds of loans had maturities shorter than one month. In interviews, market participants often stated that banks seldom lend long term, even when the loan interest rate floats. They stated that loans in the three- to five-year range are not uncommon, five- to seven-year loans are less common, and loans longer than seven years are rare. These remarks are supported by the charts.
The distributions in the charts are for a nonrandom sample of new loans, not for loans on the books.
Because very short-term loans stay on the books for only a short time, a maturity distribution for a bank's portfolio of loans at a specific time would be less skewed toward the short end. Such a distribution, however, would probably still show banks to have relatively few loans with maturities longer than seven years.
Private placements are generally intermediate to long term (charts 10 and 11). In the sample, the median nonfinancial private placement had a maturity of nine years, and the mean maturity was also about nine years. No private placements had maturities shorter than one year. 19 A moderate fraction had intermediate maturities, but about two-thirds had maturities of seven years or longer. 20 The median average life of private placements is between six and seven years; many private placements include sinking fund provisions that cause their average lives to be significantly shorter than their maturity (chart 14). 21
Nonfinancial corporate bonds issued in the public market tend to have long maturities (charts 12 and 13). The median maturity of our sample of bonds issued in 1989 was ten years, and the mean maturity almost thirteen years. Only 17 percent had a maturity of less than seven years. The median average life of public bonds was around ten years.
From the standpoint of financial theory, this cross-market pattern of maturity distributions is a bit of a puzzle. Even if long-term borrowers have a strong preference for fixed rates, banks could in principle make long-term, fixed-rate loans and execute swaps to obtain payment streams matching their floating rate liabilities. Apparently, however, they seldom do so. One explanation may be that the cost of swaps and other hedges is sufficient to make such loans unattractive to banks. Another possibility is that the different markets tend to serve borrowers that require different amounts of credit evaluation and monitoring and that in equilibrium such differences are responsible for cross-market patterns in many contract terms, including maturities.
Privately placed debt contracts almost always include strong call protection in the form of punitive prepayment penalties. 22 As discussed in section 4, buyers of private placements usually fund their purchases with long-term, fixed-rate liabilities, and call protection is an important part of their strategy for controlling interest rate risk. Prepayment penalties in the private market generally require the issuer to pay the present value of the remaining payment stream (principal plus interest at the contracted rate) at a discount rate equal to the Treasury rate plus some spread, frequently 50 basis points, but sometimes even zero. The discount rate for a nonpunitive callprotection provision includes a risk premium similar to that of the security itself (that is, associated with the credit quality of the security).
When the discount rate fails to include a sufficiently high premium, the lender realizes an economic gain if the security is prepaid, even if the security is matched with liabilities of equal duration.
In the past decade, publicly issued bonds have included increasing call protection. Crabbe (1991a) presents statistics indicating that 78 percent of public bonds issued in 1990 were noncallable for life, whereas only 5 percent of those issued in 1980 were noncallable. 23 Bank loans are typically prepayable at any time at par.
14. Distribution of average lives of fixed-rate private placement commitments measured as a percentage of the total value of new private commitments by major life insurance companies, January 1990-July 1992