Are the Distinction Between Debt and Equity Disappearing
Are the Dis~inc~ians be~:ween Debt and ;Equity Disappearing? An Overview
Richard W. Kopcke and Eric S. Rosengren*
During the 1980s, the proportion of business assets financed by debt exceeded that of any other period since World War II. Although much of this leverage accommodated new investment, during the last half of the decade corporations also replaced more than one-sixth of their outstanding stock with debt securities. Because of this surge in leverage, many analysts and policymakers are wary that businesses may have become too vulnerable, perhaps imperiling prospects for capital formation and employment opportunities. As the financial structure of businesses changed during the past decade, the characteristics of financial securities also changed. Junk bonds, variants of preferred stock, yield enhancements, warrants, and other forms of mezzanine financing became more common in credit markets and in private loan contracts. Furthermore, the potential risks and returns offered by all securities have been altered as otherwise familiar financial instruments increasingly contain novel options (puts, indexed terms, resets, auctions, caps) and as derivative securities and various swap agreements are accepted as standard financial instruments. These innovations have challenged the traditional financial and legal distinctions between debt and equity. Accordingly, public policy may need to adapt along with financial relationships, because income tax laws, regulations governing financial institutions, corporation law, and definitions of the legal rights and responsibilities of an enterprise’s
*Vice President and Economist, and Assistant Vice President and Economist, Federal Reserve Bank of Boston.
2
Richard W. Kopcke and Eric S. Rosengren
owners or creditors depend on clear boundaries to separate classes of creditors and equityholders. For example, if varieties of debt and equity instruments are more commonly regarded merely as alternative methods of
Richard W. Kopcke and Eric S. Rosengren*
During the 1980s, the proportion of business assets financed by debt exceeded that of any other period since World War II. Although much of this leverage accommodated new investment, during the last half of the decade corporations also replaced more than one-sixth of their outstanding stock with debt securities. Because of this surge in leverage, many analysts and policymakers are wary that businesses may have become too vulnerable, perhaps imperiling prospects for capital formation and employment opportunities. As the financial structure of businesses changed during the past decade, the characteristics of financial securities also changed. Junk bonds, variants of preferred stock, yield enhancements, warrants, and other forms of mezzanine financing became more common in credit markets and in private loan contracts. Furthermore, the potential risks and returns offered by all securities have been altered as otherwise familiar financial instruments increasingly contain novel options (puts, indexed terms, resets, auctions, caps) and as derivative securities and various swap agreements are accepted as standard financial instruments. These innovations have challenged the traditional financial and legal distinctions between debt and equity. Accordingly, public policy may need to adapt along with financial relationships, because income tax laws, regulations governing financial institutions, corporation law, and definitions of the legal rights and responsibilities of an enterprise’s
*Vice President and Economist, and Assistant Vice President and Economist, Federal Reserve Bank of Boston.
2
Richard W. Kopcke and Eric S. Rosengren
owners or creditors depend on clear boundaries to separate classes of creditors and equityholders. For example, if varieties of debt and equity instruments are more commonly regarded merely as alternative methods of