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THE ECONOMICS OF THE PRIVATE MARKET

Types of Payment Stream and Yields

Most bank loans carry floating interest rates, whereas most private and public bond issues carry fixed rates. Only 3 percent of commitments by major life insurance companies to purchase private placements from January 1990 to July 1992 carried floating rates. Only 95 of the 1,588 private placements of debt recorded in the Investment Dealers Digest (IDD) database for 1989 are listed as having floating rates. 24  The 95 represented 6 percent of issues and accounted for 14.3 percent of volume. However, many of the floating-rate financings in the IDD sample may, in effect, have been bank loans, so the latter statistics probably substantially overstate the fraction of private placements with floating rates. 25  About 5 percent of the volume of public bonds issued in 1989 had variable rates.

Publicly available data on private placement yields in recent years are limited. 26  However, many market participants stated that the yield spreads over Treasuries on traditional investmentgrade private placements are higher than the spreads for publicly issued bonds with similar credit risk. The average differential between private and public spreads varies over time, but participants spoke of a range of 10 to 40 basis points. The differential is often called a liquidity premium, but it must also compensate lenders for any costs of credit evaluation and monitoring. The term credit analysis premium might be more appropriate.

Some market participants noted that spreads on investment-grade private placements are occasionally lower than those on comparable publics for very brief periods, up to a few days. They attributed this difference to slower adjustment of the private market to changes in the yield curve.

Spreads on below-investment-grade private placements have often been below those on comparable public junk bonds. Investors may demand larger risk premiums on public junk bonds because employing the risk control technologies of lender due diligence and loan monitoring is more difficult in the public markets or because comparatively rated public issues actually are riskier.

Several researchers have examined the relation between issuer quality and yield spread in alternative markets by focusing on the difference between the private placement and the public bond markets. For the 1951-61 period, Cohan (1967) found that the spread between yields on private placements and yields on public bonds rose as the credit quality of the issuer increased. Thus, the private placement market was relatively more attractive for lower quality credits. In a study that controlled for the restrictiveness of covenants, Hawkins (1982) confirmed this result for the period 1975-77. 27  These results are consistent with our discussions with market participants, who indicated that the public market tended to have relatively little appetite for small-sized, lowquality issues. However, this statement does not necessarily hold for larger-sized, low-quality securities. The development of the junk bond market in the 1980s produced a competitive public market for large, non-investment-grade bonds.  Thus, Cohan's and Hawkins's findings may not hold for larger issues in the second half of the 1980s. Moreover, the credit crunch in the belowinvestment-grade sector of the private placement market since mid-1990 has led to a significant increase in the average spreads for belowinvestment-grade private placements of all sizes.

  1. These statistics are for all placements in the IDD database, not just issues of nonfinancial corporations. If the same sample of nonfinancial business nonconvertible debt that was the basis of issue-size and maturity statistics is used, 4.5 percent of the number and 13.8 percent of the volume have floating rates.

  2. The IDD database was obtained from IDD Information Services. The data on insurance company commitments are from the American Council of Life Insurance. In a database of bank loans and private placements produced by Loan Pricing Corporation, many of the transactions listed as private placements and as having floating rates involved only commercial banks as lenders, providing further evidence that the IDD sample overstates the fraction of placements with floating rates.

  3. See part 3, section 1, for charts of a few yield series.

  4. Shapiro and Wolf (1972) argue that the relationship between the private-public spread and quality is positive because private securities have more restrictive covenants, particularly at the lower quality levels. However, Hawkins (1982) found no relation between covenant restrictiveness and quality for his sample of private placements. Hawkins's result is an anomaly; other research and our interviews support the view of a positive relationship between the private-public spread and credit quality, at least until the recent credit crunch in the below-investment-grade sector of the private placement market. However, no empirical test has been adequate to support or disprove Shapiro and Wolf's contention that the positive relationship was due strictly to differences in covenant protection between the markets. Our discussions with market participants suggest that, until the recent crunch, the private placement market was generally more receptive than the public market to small-sized, lower-grade issuers.

Variety of Securities

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