Regulated investors’ restricted choices can make high-grade bond financing a super-premium strategy

Evidence

Since many investors in the modern world are seriously circumscribed in their actions, there is an opportunity to increase the total investment value of an enterprise by effective bond financing. Economic theorists are fond of saying that in a perfectly fluid world one function of the market is to equalize risks on all investments. If the yield differential between two securities should be greater than the apparent risk differential, arbitragers would rush into the breach and promptly restore the yield differential to its proper value. But in our world, arbitragers may have insufficient funds to do their job because so many investors are deterred from buying stocks or low-grade bonds, either by law, by personal circumstance, by income taxes, or even by pure prejudice. These restricted investors, including all banks and insurance companies, have to bid for high-grade investments almost without regard to yield differentials or the attractiveness of the lower grade investments. And these restricted investors have sufficient funds to maintain yield differentials well above risk differentials. The result is a sort of super premium for safety; and a corporation management can take advantage of this super premium by issuing as many bonds as it can maintain at a high rating grade. — Donald MacKenzie, An Engine, Not a Camera, 191

Categorization

• DEFINE: This defines the pre-Modigliani-Miller orthodoxy that capital structure could be actively managed to exploit yield differentials, a baseline against which the irrelevance theorem is measured.
• XREF: Connects to the broader financialization literature on how regulation and investor constraints segment markets and create pricing anomalies. — connects to: Credit-risk regulation imports market-finance models developed for traded securities. — Ève Chiapello, Financialisation of Valuation, 60; Bond buy-and-hold investors create a liquidity premium for newly issued bonds — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 953; Asset-specific investment locks firms out of market-based price discipline — Diego Gambetta, Trust - Making and Breaking Cooperative…, 2576

Broader Connections

• Bond buy-and-hold investors create a liquidity premium for newly issued bonds #complicates (0.85) — Donald MacKenzie, An Engine, Not a Camera, 953
• Asset-specific investment locks firms out of market-based price discipline #expands (0.75) — Diego Gambetta, Trust - Making and Breaking Cooperative…, 2576