1 IN SEARCH FOR THE RIGHT METRIC FOR CORPORATE BOND MARKETS IN ARGENTINA Primer Seminario LarrainVial de Renta Fija “Latinoamérica, Renta Fija Local – Una Nueva Clase de Activos” Santiago, Chile. 20 de Abril de 2007 Sergio Pernice, Universidad del CEMA Roque Fernández and Jorge Streb, co-authors

2 Are Latin American bond markets underdeveloped?

3 Firm Size and the Use of Bonds by Argentinean Corporations There is a very small proportion of big firms in Argentina Only Big firm use Bonds as a form of credit –“…Banks and bond markets, according to conventional theory, have different natural clienteles. Banks can economically provide finance for smaller borrowers, while bond markets, where issues are subject to a substantial minimum efficient scale, can do so at lower cost for large corporations with substantial funding needs…”

4 Conceptual Framework: Modigliani-Miller (M&M) equivalent proposition [(A  B)  (-B  -A)] If the value of the firm is not independent of its financing policy (as is empirically the case), then it must be because the financing policy: (i)Must affect taxes paid by issuers or investors, given the specificities of corporate and personal taxes, or (ii)Must affect management’s incentives to follow the value- maximizing rule of investing in all positive NPV projects, or (iii)Must affect contracting costs (this may include costs of issuing debt, the probability and costs associated to getting into financial difficulty or bankruptcy, etc.), or (iv)Must provide a credible signal to investors of management’s confidence (or lack thereof) about the firm’s future earnings, in a context of information costs and asymmetric information

5 Evidence from US Firms The second reason --incentive problems-- is by far the most important determinant of leverage level (Barclay, Smith, and Watts 1999) Proxies: market-to-book ratio and tangibility of assets The particular debt instrument chosen, which in turn affects the maturity of the debt, is also affected strongly by the third reason --cost of issuing debt-- (Barclay and Smith 1999) Proxy: firm size We conjecture the same for LA and in particular Argentinean Firms

6 Taxes Taxes (first reason) –The market for bonds started to take off when modified in 1991 by Law to level field with bank loans, that had tax advantages

7 Econometric estimates Source: Economatica, firms quoted on stock exchanges Bi-annual panel data, Tobit specification as in Rajan & Zingales (1995): y i =  +  1 size i +  2 tang i +  3 q i +  4 roa i + u i Control for year

8 Econometric results Tobit estimates: leverage: size not significant share short term debt: size (-), statistically significant and economically important bond ratios: size (+) Probit estimates: issue of bonds: size (+), big firms issue

9 Effect of size on bond ratios

10 Survey: Sample Our Base: Companies > 200 employees or > 150MM pesos annual revenues.

11 Question 3: Have you issued Bonds? Big firms: assets > USD 200MM Small: assets < 200MM

12 Question 5: To what extent the following factors represent a problem for financing through bonds, either domestic or foreign bonds? Fees are cheaper in Argentina than abroad (reasonable after the devaluation) They have strong scale economies –While for big firms this seems not to be an important problem, it is so for small firms –This result agrees with the standard theory of bond financing

13 Question 6: To what extent the following factors are a problem for financing their operations with Domestic Banks and Domestic Bonds?

14 Question 6: To what extent the following factors are a problem for financing their operations with Domestic Banks and Domestic Bonds? Small firms basically do not use bonds as a form of financing

15 Question 7: Order, for each attribute, the relative advantages of different forms of credit (1 is best, 5 is worst).

16 Survey to the Demand side (41 answers) Question 4: main factors that limit the demand for Corporate Bonds Low liquidity of the secondary market was the most important factor limiting the demand for Corporate Bonds (80%)

17 Prediction on number of firms using bonds (2005) Number of firms in survey with bonds outstanding: 8 All but one have: –More than 1500 employees –Revenues greater than 219 MM pesos Number of firms with bonds outstanding –2004: 68 –2005: 56 The proportion of firms in the survey that use bonds, multiplied by the number of firms in the economy that meet the criteria to be in the survey gives numbers very similar to these numbers

18 Size of the firms is the relevant variable to understand use Bond as a form of financing Econometric results and Survey confirm this But there are many different criteria of “size”, which one is the relevant to understand Bond Market development?

19 Back of the envelope calculations on size of corporate bond market

20 Firm Size and Bond Market Size Bonds as share of GDP is misleading ratio –Bonds Outstanding is inter-temporal concept –GDP is one year concept Bonds Outstanding / Firm Value is a more reasonable measure –Bonds Outstanding = PV debt –Firm Value = PV cash flows –Part of these cash flows will be used to pay debt

21 Back of the envelope calculations on size of bond market

22 Are Latin American bond markets underdeveloped?

23 Are Latin American bond markets underdeveloped?

24 Are Latin American bond markets underdeveloped? Perhaps, but our research points to another question: –Why is the market value of firms so small in Argentina, and Latin America?