Financial innovations and excesses revisited: the case of auction rate preferred stock - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Michael J. Alderson, Donald R. Fraser

The yield advantage under the same pre-tax yields has dropped to 58 basis points under the revised tax law. The narrower spread results from the lower corporate tax rate which raised the after-tax money market yield to 6.6% and the reduced dividend exclusion which lowered the after-tax auction rate yield to 7.18%. In a Scholes and Wolfson |10~ framework, investors would respond to the increased explicit tax on preferred stock by demanding a higher pre-tax dividend yield, in order to restore the previous risk-adjusted, after-tax return spread between auction rate preferred and fully taxable securities. The result would be an increase in the cost of preferred equity financing.

The Tax Reform Act of 1986 also eliminated the investment tax credit and lengthened the period over which corporate assets could be depreciated for tax purposes. These changes reduced the amount of nondebt tax shields available to offset taxable corporate income, potentially increasing the effective marginal corporate tax rate. Auerbach |3~ has shown that the reduction in nondebt tax shields more than offset the impact of the decreased statutory corporate tax rate, resulting in a net increase in the effective marginal tax rates of industrial companies. All other things equal, an increased marginal corporate tax rate would increase the relative cost of preferred equity by lowering the absolute cost of debt financing.

In summary, a confluence of changes in the tax code would appear to have increased the relative cost of auction rate preferred stock by (i) decreasing the implicit tax subsidy on preferred dividends and (ii) increasing the explicit tax subsidy to debt financing. Independent of the reduced tax benefits, however, the high interest rates that helped to spawn the initial demand for auction rate preferred have since abated, thereby reducing rewards to investing in auction rate shares. To demonstrate, recall that the pre-tax yields shown in Exhibit 1, which are representative of yields prevailing when auction rate preferred stock was introduced (August 1984), implied an after-tax yield advantage of 205 basis points. Given the secular decline in interest rates since that time, the yield advantage to auction rate preferred has been reduced in absolute value: at pre-tax yields of eight percent and 6.4 on money market and auction rate instruments, respectively, the after-tax yield on auction rate preferred currently exceeds the after-tax return to money market securities by only 47 basis points. The difference is even smaller for lower pre-tax yield spreads.

Van Horne's analysis also seems to imply, however, that the benefits of auction rate preferred stock to both purchasers and issuers were initially oversold. Such would be the case if (i) corporate investors overestimated the benefits of the dividends-received deduction relative to the incremental risk associated with preferred equity and/or (ii) corporate issuers underestimated the risk of rising dividend rates. Unfortunately, we cannot directly estimate the relative increase in the cost of auction rate preferred, nor the degree of disappointment experienced by corporations that redeemed their shares. Instead, we conducted a mail survey of corporations that redeemed auction rate preferred shares in an attempt to identify additional causes for the surge in redemption activity over the period 1988-1991.