Revenue Rise with Loans

Northwest Airlines and KLM decided what they wanted from each other and used the term alliance to describe their relationship. They structured their partnership as an interdependent relationship— that is, maintaining two separate corporate identities but acting as a single company in the eyes of their customers, allowing them to:

• Code-share, which gives them the ability to book reservations on each other’s flights using a single reservation system and flight numerics
• Share ticket check-in and baggage-loading facilities
• Share catering services
• Share warehouse capabilities
• Purchase materials jointly, reducing cost through volume
• Market jointly and cross-sell into each other’s territory

This principle of maintaining interdependence is more difficult to envision when the companies working together are in different fields. When a partnership involves two different businesses, each partner’s needs and capacities must be spelled out. McDonald’s founder Ray Kroc was famous for partnering with the suppliers for his growing business. His business was selling fast food to millions of consumers, building restaurants, and investing in real estate. Even though he could have bought out the entire operations of many of his suppliers, he didn’t. He wanted to maintain partnerships, believing that people who owned their own business were more productive. He went so far as to insist on paying a fair price to his suppliers rather than squeezing them for bargain-rate concessions, which he could have done.

I once worked with a telecommunications company whose mission included the goal “to maximize our stock portfolio.” The leadership decided this meant they should partner with a financial institution in order to manage their portfolio more efficiently. What they needed was a partner to help them—an investment bank—but what they did was acquire a bank and attempt to run it themselves. The company tried to run the bank the same way it ran its telephone operations—and the bank’s operations suffered. The leadership could not adjust to the fast pace of decision making required in financial institutions.

Interest and currency markets can change almost hourly. The telecommunications firm, used to a slower pace due to regulatory bureaucracy, just couldn’t make decisions fast enough. More important, its mission of maximizing its portfolio was distorted by the idea that it should manage this function itself.

After spending millions of dollars purchasing the bank and subsidizing its operations, the company sold it at a loss of many more millions of dollars. Because this was not a true partnership, it failed. Taking over is not partnering; it’s simply a conquest. The structure of the partnership should preserve both partners’ ability to contribute to the other. If your partner loses independence or can’t maintain a separate identity, your partnership ceases to exist.

The independent system of doing business no longer works. Today the workplace rallying cry is teamwork. Organizations are becoming interdependent and relying on others to help them accomplish their goals. They’re moving toward more openness and creating organizational cultures that support it. The Partnership Continuum model helps partners assess where they are in this transition. As a partnership develops, it moves from being closed and solitary to being open and interdependent. By building relationships based on trust and by producing mutual benefits, the partnership can be longlasting.

Interdependence can be defined as two (or more) independent entities working together as partners without losing their separate identities. Interdependent partnerships succeed because each party needs assistance in achieving its goals and each contributes to satisfying the needs of the other partner. Approaching a partnership with the hope of simply buying a needed capability is not only shortsighted and naïve—it can have dire consequences.

At this point a vice president at the mortgage servicer urged me to work on improving their process. The first thing I did was bring the servicer and custodian together to talk about the tracking issue. After several meetings, we agreed to try working together to integrate their two processes. Using the Partnership Continuum model, we started off by assessing and defining our needs. Once both parties agreed that they needed to get the correct document delivered to the correct location in time for the closing, we created a vision for the partnership. We then started on the initial activity: to document the two organizations’ processes, set standards, and create a measurement system.

After several months, the firm of mortgage servicers was able to improve its on-time delivery to closers by 200 percent. After one year, it had one of the best records in the business. Bob later confided that initially he hadn’t believed we’d improve things.He’d felt that the custodians had spent too much money on their delivery system without
consulting customers and that they would never change it. But partnering with the custodian and creating a sense of interdependence proved otherwise.

The asymmetric distribution of corporate bond returns is easily explained by the Merton model introduced earlier. Numerous studies substantiate that even the return distributions of less risky and more liquid asset classes like government bonds are skewed and leptokurtic. Moreover, index returns exhibit significant autocorrelation that can be explained partially by a permanent component. Basically, bond returns are a result of price movements, interest accrual, pull to par, and roll down of the yieldcurve effects. While the first component is highly variable the other three
components are rather stable over time.

Because of their long history and good data reliability the empirical study is based on Merrill Lynch indices for the period January 1987 to September 2003. So the sample period comprises 201 months, spanning more than two business cycles. It contains the 1989/90 US recession, two periods of dramatic Fed tightening, the Tequila crisis in 1994, the Asian crisis in 1997, and Russia’s default in 1998. Driven by a secular trend of disinflation the yield of 10-year treasury notes declined from 7.2 to 3.9 percent in this period. With regard to future return expectations this should be kept in mind.

A special situation occurs in the high-yield sector. The illiquidity in large parts of the universe causes price lags meaning that the aforementioned small changes in credit quality are not immediately reflected in bond prices. In the economic literature, this effect is known as non-trading. With respect to high-yield indices non-trading and non-synchronous trading of index bonds can lead to autocorrelation of returns. Therefore, estimates of the index volatility for illiquid asset classes can be distorted. Usually the true volatility of illiquid asset classes is underestimated. In a portfolio context too large portfolio weights are the consequence. Especially portfolios constructed in the classical mean–variance framework suffer from that problem.

Mean–variance analysis, made popular by Markowitz and Sharpe, has been the basis for the process of portfolio optimization since the 1990s. Yet, the method itself suffers from various pitfalls. Among others it ignores deviations of the return distributions from normality. The asymmetric risk profile of corporate bonds and the illiquidity of certain segments of the international corporate bond markets make great demand on the process of portfolio construction. Merton (1974) clarified that corporate bonds can be replicated by the combination of a riskless bond and a short put on the assets of the company. This shows that the return potential of corporate bonds is somewhat constrained whereas the possible loss in the event of default is only limited by the recovery. Between 2000 and 2002, spectacular defaults like Enron and WorldCom heightened the sensitivity of investors to the risks associated with credits. In general the following relation holds: the higher the leverage of an issuer, the higher the credit risk. Remember that the short-put option on the assets of a highly leveraged issuer is much closer at-the-money than that of a conservatively financed company. And the closer the short put option is at-the-money the more asymmetric becomes the risk profile of a corporate bond. For those issuers small changes in credit quality such as, for example, due to increased dividend payments, can lead to significant volatility of spreads and corporate bond prices.

Clearly investors willing to allocate a part of their budget to corporate bonds are facing two questions. First, they have to decide how much of their budget they want to invest in corporate bonds. In this context we will focus on a pure fixed income portfolio. Usually private as well as institutional investors define their long-term asset allocation with respect to the asset classes such as stocks, bonds and real estate in a preliminary process.

The second decision concerns the sector allocation of the portfolio which is part of the tactical asset allocation. As noted before, the sector allocation of a corporate bond portfolio essentially determines its risk/return profile and portfolio beta.

Having focused on indicators for the overall level of leverage so far, we will now switch to metrics that relate the ability to generate cash flows and profits to the interest burden. This helps to better capture liquidity problems in the short term, but goes at the expense of understanding the longer term vulnerability of the corporate sector due to leverage. Although facts seems to show a long-term upward trend in the ratio of net interest payments to cash flows, one can argue that the level reached in 2003 roughly represents the average over the last 35 years. The rise in the overall level of indebtedness in this period has coincided with significantly falling interest rates, keeping the interest burden for the companies on a manageable level.

Like the ratio of net interest payments to cash flows, interest coverage, defined as the ratio of profits to net interest payments, has remained in a range since 1970. Again, as one might expect, when net interest payments are better covered by the level of profits, creditworthiness improves, and credit spreads tighten. But interest coverage in 2003 was still near its cyclical low, indicating weak profitability in the nonfinancial corporate sector and a lack of top-line growth. Considering the fall in yields, the low level of interest coverage is problematic. Partially it results from the fact that not only the companies’ liabilities are interest-rate sensitive, but also the value of a part of the assets depends on the level of interest rates.

While the choice of the most appropriate measure of corporate leverage is an arbitrary task, empirical studies indicate that the financing gap is able  to explain a lot of the variance in credit spreads. It is defined as the difference between capital expenditures, including outlays for inventories, and the amount of cash that corporations need to raise in order to finance their investment plans, expressed as a percentage of nominal GDP. The rapid rise in this metric was a powerful warning sign at the end of the 1990s that capital spending was overextended. As one usually observes at the end of recessions, the financing gap has not only closed after the 2001 recession, but fell substantially below its long-run average. In 2003, after-tax cash flow exceeded capital outlays, which is a rare occurrence. In the past, this was usually a good sign for capital spending. Intuitively, the US Treasury replaced the corporate sector as a financier for business spending.

Via tax cuts it provided the corporate sector with capital, thereby raising after-tax cash flow, and reducing the requirement for external financing through corporate debt issuance. The increasing amount of Treasury supply, combined with deleveraging in the corporate sector contributed significantly to corporate spread tightening between autumn 2002 and 2004.