On the Value of Municipal Bond Insurance: An Empirical Analysis

Using a large sample of municipal bond data from 2001 to 2010 in the U.S., this paper documents the time variation of the value of municipal bond insurance, estimated from the insured and uninsured bonds yield at issue differentials. We find that insured municipal bonds carry significant lower yields at issue compared to those of the equivalent uninsured bonds before 2008. However, this cost saving disappeared with the aftermath of the subprime credit crisis. We find that the supply of bonds and the level of market interest rates to have significant positive impacts on the time‐varying value of bond insurance. We also detect asymmetric response of these yield differentials to rises and declines of market interest rates. Economic intuition suggests that the value of municipal bond insurance is a function of business cycles but our tests support the contrary, which may be explained by the habitat preference of municipal bonds issues.     

THE SLOPE OF THE TERM STRUCTURE OF CREDIT SPREADS: AN EMPIRICAL INVESTIGATION

In this article we analyze the slope of the term structure of credit spreads. We investigate the explanatory role of interest rate, market, and idiosyncratic equity variables that the recent empirical literature highlights as important determinants of credit spread levels. This study extends the analysis and assesses its effect on credit slopes for a sample of corporate bonds. We find that these factors affect credit spreads at short and long maturities in a significantly different way. A closer inspection of the credit spread slope also reveals that it is a useful indicator of the direction of changes in future short‐term credit spreads. This evidence has important implications for the trading and risk management of portfolios of bonds with different maturities.     

Capitalizing on Catastrophe: Short Selling Insurance Stocks Around Hurricanes Katrina and Rita

We develop several hypotheses regarding short‐selling activity around Hurricanes Katrina and Rita. We find that abnormal short selling does not increase until 2 trading days after the landfall of Katrina and that short‐selling activity is much more significant around Rita. We find a substantial increase in short‐selling activity in the trading days prior to the landfall of Rita and relatively less short‐selling activity in the trading days after landfall. There is little evidence that suggests that traders short insurance stocks with more potential exposure in the Gulf region than other insurance stocks in the days before landfall.     

Advance Refundings of Municipal Bonds

The advance refunding of debt is a widespread practice in municipal finance. In an advance refunding, municipalities retire callable bonds early and refund them with bonds with lower coupon rates. We find that 85% of all advance refundings occur at a net present value loss, and that the aggregate losses over the past 20 years exceed $15 billion. We explore why municipalities advance refund their debt at loss. Financially constrained municipalities may face pressure to advance refund since it allows them to reduce short‐term cash outflows. We find strong evidence that financial constraints are a major driver of advance refunding activity.     

CREDIT SPREADS AND THE ZERO‐COUPON TREASURY SPOT CURVE

We examine the relation between credit spreads on industrial bonds and the underlying Treasury term structure. We use zero‐coupon spot rates to eliminate the coupon bias and to allow for a consistent study both within and across the different credit ratings. Our results indicate that the level and slope of the Treasury term structure are negatively correlated with changes in the credit spread on investment‐grade corporate bonds. We also find that the relation between credit spreads and the Treasury term structure is relatively stable through time. This is good news for value‐at‐risk calculations, as this suggests that the correlations among assets of different credit classes are stable; therefore use of historic correlations to model spread relations can be valid.     

Performance measures and short‐termism: An exploratory study

We examine the relationship between performance measurement systems and short‐termism. Hypotheses are tested on a sample of senior managers drawn from a major telecommunications company to determine the extent to which the diagnostic and interactive uses of financial and non‐financial measures give rise to short‐termism. We find no evidence to suggest that the use of financial measures, either diagnostically or interactively, leads to short‐term behaviour. In contrast, we find a significant association between the use of non‐financial measures and short‐termism. Results suggest that the diagnostic use of non‐financial measures leads managers to make inter‐temporal trade‐off choices that prioritise the short term to the detriment of the long term, while we find interactive use is negatively associated with short‐termism. We find an imbalance in favour of the diagnostic use over the interactive use of non‐financial performance measures is associated with short‐termism. Overall, findings highlight the importance of considering the specific use of performance measures in determining the causes of short‐termism.     

Consumption risk and the cross-section of government bond returns

In this paper we provide a consumption-based explanation of risk in nominal US Treasury bond portfolios. We use a consumption-CAPM with Epstein–Zin–Weil recursive preferences. Our model introduces two sources of risk: uncertainty about current consumption (reflected in contemporaneous consumption growth) and uncertainty about prospects of consumption in a long run (reflected in innovations to expectations about future consumption growth). We use a novel approach to estimate pricing factors in our model: we employ a factor-augmented VAR model with common factors, extracted from a large panel of macroeconomic and financial data, as state variables. We find that the important source of risk in US bonds is related to uncertainty in prospects in future consumption and it induces a positive and significant risk premium. We find as well that covariance risk related to innovations in expectations about future consumption growth is greater for long term bond portfolios than for short term bond portfolios, which is consistent with a duration measure of risk and justifies why long term bonds require greater premium than short term bonds. Our model explains well the cross-sectional variation in average excess returns of bonds with different maturities over the period 1975–2011 and compares favorably with competing models.     

Board Effectiveness and Short Termism

We examine whether more effective boards in terms of size, experience, shareholding and independence, as discussed in the 2010 UK Corporate Governance Code, limit excessive short‐term risk taking or short‐termism. We use a state‐of‐the‐art asset pricing model that enables the disentangling of short‐term risk (related to short‐term returns) and long‐term risk (related to long‐term returns), and use the former as a proxy for short‐termism, where the short‐term component not only represents the time horizon for which we are interested but also the risk that is not related to fundamentals. We examine 916 firms in the UK over a possible horizon of 18 years, January 1992–December 2010, and find that more effective boards are associated with lower levels of short‐term risk and this result is robust to various types of short‐term risk (overall, downside) and specifications.     

Insurance, Bond Covenants, and Under- or Over-investment With Risky Asset Reconstitution

Traditional theory predicts that the shareholders of a limited liability company financed partly by bonds may underinvest by not replacing damaged company assets. It also precludes the possibility of overinvestment. By relaxing the restrictive assumption maintained under traditional theory, namely, that the effects of reconstituting damaged assets are nonstochastic, this article shows that both over and underinvestment are possible. It is shown that these moral hazard problems can be mitigated by incorporating appropriate insurance requirements into bond covenants. Moreover, it is shown that the insurance requirements for alleviating underinvestment and overinvestment are quite different. Particularly, for underinvestment, the required insurance only needs to make the bonds riskless in the best asset reconstitution states of the loss states in which the company value falls short of the promised bond repayment; however, for overinvestment, the required insurance should make the bonds totally riskless. The difference in insurance requirements is especially important when insurance is actuarially unfavorable such that more‐than‐required insurance is always undesirable.     

Bond Insurance: What Is Special About Munis?

Close to 50% of municipal bonds are prepackaged with insurance at the time of issue. We offer a tax‐based rationale for the emergence of third‐party insurance of tax‐exempt bonds. We argue that insurance adds value as it allows a third party to become, in a probabilistic sense, an issuer of tax‐exempt securities. Insurance however reduces value by eliminating the possibility of a capital tax loss. While the net benefit from insurance increases with bond maturity, the benefit may not increase monotonically with default risk. We also provide empirical evidence supportive of the model's predictions.     

Reversal and momentum patterns in weekly stock returns: European evidence

We analyze short‐term reversal and medium‐term momentum patterns in weekly stock returns in Europe. Focusing on raw and stock‐specific returns, our empirical results show for both return specifications (a) a negative relation between weekly past returns and future returns in the short run and (b) a positive relation in the medium run. However, returns from reversal and momentum strategies based on stock‐specific returns are less volatile. In further analyses, we find short‐term reversal and medium‐term momentum patterns to be connected to stock characteristics. Looking at the potential causes of these effects, our results do not support the idea that short‐term reversal in weekly stock returns is due to an over‐ or underreaction to firm‐specific news nor that it is mainly driven by illiquidity. Medium‐term momentum in weekly stock returns, on the other hand, can be connected to behavioral biases. Our concluding tests confirm that our findings are robust among industries, in subperiods, for the January effect and in varying market states. Finally, while medium‐term momentum strategies remain profitable after accounting for transaction costs, short‐term reversal strategies can be mainly explained by transaction costs due to their high turnover.     

Medicaid and long‐term care: The effects of penalizing strategic asset transfers

Medicaid provides a critical source of insurance for long‐term care, and individuals may strategically offload assets (typically to children) to meet the means‐tested eligibility requirement. In this article, we quantify the extent of such behavior using variation in the penalty for improper parent‐to‐child transfers induced by the Deficit Reduction Act of 2005. We estimate difference‐in‐differences models based on the hypothesis that only individuals with high levels of nursing home risk (high risk) will alter transfers because of the Act. We find that over a 2‐year horizon, high‐risk individuals reduced transfers to children on the extensive margin by 11 percent and that the average total amount of transfers decreased by $4,860. The results hold only for coupled respondents. We also conduct a triple‐differences analysis to examine heterogeneity with financial literacy and find that even those with a low level of financial literacy responded to the penalty.     

Investment Horizon and Repo in the Over‐the‐Counter Market

This paper presents a three‐period model featuring a short‐term investor in the over‐the‐counter bond market. A short‐term investor stores cash because of a need to pay cash at some future date. If a short‐term investor buys bonds, then a deadline for retrieving cash lowers the resale price of bonds for the investor through bilateral bargaining in the bond market. Ex‐ante, this hold‐up problem explains the use of a repo by a short‐term investor, the existence of a haircut, and the vulnerability of a repo market to counterparty risk. This result holds without any uncertainty about bond returns or asymmetric information.     

Do U.S. Insurance Firms Offer the “Wrong” Incentives to Their Executives?

We examine the relation between executive compensation and market‐implied default risk for listed insurance firms from 1992 to 2007. Shareholders are expected to encourage managerial risk sharing through equity‐based incentive compensation. We find that long‐term incentives and other share‐based plans do not affect the default risk faced by firms. However, the extensive use of stock options leads to higher future default risk for insurance firms. We argue that this is because option‐based incentives induce managerial risk‐taking behavior, which seeks to maximize managerial payoff through equity volatility. This could be detrimental to the interests of shareholders, especially during a financial crisis.     

Predictable Investment Horizons and Wealth Transfers among Mutual Fund Shareholders

This study analyzes the distribution of investment horizons in a large, proprietary panel of all shareholders in one no‐load mutual fund family. A proportional hazards model shows that there are observable shareholder characteristics that enable the fund to predict reliably on the day each account is opened whether the account will be short term or long term. Simulations show that the liquidity costs imposed on the fund by the expected short‐term shareholders are significantly greater than those imposed by the expected long‐term shareholders. Combining these results, the analysis argues that mutual funds do not provide equitable liquidity‐risk insurance.     

Financial Transaction Taxes,Market Composition,and Liquidity

We use the introduction of a financial transaction tax (FTT) in France in 2012 to test competing theories on its impact. We find no support for the idea that an FTT improves market quality by affecting the composition of trading volume. Instead, our results are in line with the hypothesis that a lower trading volume reduces liquidity and in turn market quality. Consistent with theories of asset pricing under transaction costs, we document a shift in security holdings from short‐term to long‐term investors. Finally, we find that moderate aggregate effects on market quality can mask large adjustments made by individual agents.     

How does the insurer's mobile application sales strategy perform?

While the impact of an Internet-based sales strategy on sales performance has been well studied, there is little academic research that examines the impact of a mobile application (MA) sales strategy on the sales performance of insurers. Using a unique data set for term life insurance policies from a Chinese life insurer, we study the impact of implementing this strategy on insurance purchases. We find a significant growth in the insurance purchase quantity and somewhat lower growth in premiums received from new policies. This paper determines that this is due to improved channel accessibility and the cost reduction of the MA channel. Although sales of traditional distribution channels are cannibalized in the short term by the MA distribution strategy, this substitution effect does not persist in the long run. In addition, we find that this strategy reduces impulsive purchases.     

Household Life Cycle Protection: Life Insurance Holdings, Financial Vulnerability, and Portfolio Implications

Using the Survey of Consumer Finances, we examine the life cycle demand for different types of life insurance. Specifically, we test for the consumer's aversion to income volatility resulting from the death of a household's wage‐earner through the purchase of life insurance. We first develop a financial vulnerability index to control for the risk to the household. We then examine the life cycle demand for life insurance using several definitions of life insurance. We find, in contrast to previous research, that there is a relationship between financial vulnerability and the amount of term life or total life insurance purchased. In addition, we find older consumers use less life insurance to protect a certain level of financial vulnerability than younger consumers. Secondly, our study provides evidence that life insurance demand is jointly determined as part of a household's portfolio. Finally, we consider the impact of family members' nonmonetary contribution on the household's life cycle protection decision. Our results provide some evidence that households take into account the value of nonmonetary contribution in their insurance purchase.     

Financial Innovations,Money Demand,and the Welfare Cost of Inflation

In the 1990s, the empirical relationship between money demand and interest rates began to fall apart. We analyze to what extent financial innovations can explain this breakdown. For this purpose, we construct a microfounded monetary model with a money market that provides insurance against liquidity shocks by offering short‐term loans and by paying interest on money market deposits. We calibrate the model to U.S. data and find that the introduction of the sweep technology at the beginning of the 1990s, which improved access to money markets, can explain the behavior of money demand very well. Furthermore, by allowing a more efficient allocation of money, the welfare cost of inflation decreased substantially.