...saving. is intriguing: how can an emerging market issuer with junk bond ratings obtain such low yields? We argue ownership restrictions enhance value since they enable an issuer to precommit to renegotiate efficiently with a favored clientele in the potential default states, thereby circumventing deadweight costs of prolonged negotiations, particularly when the restricted clientele also values the underlying collateral higher than other investors. Ownership restrictions can also result in a transfer of value from holders of unrestricted bonds to holders of restricted bonds because of implicit seniority of the latter. We empirically test and find support for both value enhancement and value transfer and show robustness to several alternative explanations. Our evidence suggests' that firms can benefit from designing securities with ownership restrictions, by offering new securities exclusively to investors who value them the most.

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The literature on security design has typically given relatively little attention to the role of ownership restrictions in designing securities. (1) Interestingly, few articles in this area suggest restricting ownership in any fashion. The general view is that ownership restrictions are unnecessary or even detrimental. They are unnecessary because investors can self-select which securities they wish to hold (therefore, there is no need for a firm to restrict securities ex ante). They can be detrimental because ownership restrictions can affect demand, leading to a negative effect on a security's price because of constriction of demand. (2)

We hypothesize and present evidence that ownership restrictions can be beneficial to an issuer in obtaining higher prices (lower yields) for its bond offering to a targeted clientele. We present evidence from a natural experiment: multiple events of capital raising totalling $9.7 billion by an emerging market issuer (namely, India's largest bank, the State Bank of India) exclusively from Indians living abroad. We provide evidence that these bonds were priced substantially higher than comparable emerging market debt leading to a difference of about 150 basis points in yields which translates into large bottom line savings of over a billion dollars. We confirm this difference using a variety of methods including matching procedures based on Near Neighbor, Gaussian, and Epanechnikov kernel based estimators (see Heckman, Ichimura, and Todd, 1997, 1998), as well as regression based yield estimators. This is an intriguing issue because it raises the question, how can an issuer with a junk bond rating (India's credit rating at that time) obtain such low yields (high prices)? And are there lessons inherent in this security design that can be replicated elsewhere?

There are a number of reasons why a niche clientele may value a security more. First, there may be a perceived difference in credit rating by the niche clientele. A second reason is that a niche clientele may value the underlying collateral in the potential default states more than other investors. (3) For example, India may default if it does not have enough foreign exchange reserves, and it is plausible that they would pay in the local currency (Indian Rupees), which are not freely convertible into US dollars. Who values collateral in Indian Rupees more? Naturally, the Indians living abroad because they face a lower transaction cost in using the local currency (e.g., for purchase of real estate, jewelry, family support payments etc.--see Appendix A for details). Thus the value in the potential default states, and hence the expected value, ex ante is higher for this niche clientele. Finally, renegotiation costs are lower when a firm deals with a homogenous clientele in the default states. Gilson, John, and Lang (1990) provide related empirical evidence from the bankruptcy literature, and show that firms with more layers of creditors are less likely to restructure privately, out of court, an alternative that is less expensive than a bankruptcy court. Furthermore, these renegotiation costs are even lower if the niche clientele has reasons to value the underlying collateral more as suggested above.

The above mentioned reasons explain to some extent why a niche clientele has a higher expected valuation and is willing to pay more than other investor clienteles for the securities offered by the issuer. However, none of the above reasons by themselves explain why ownership restrictions are necessary. If the securities are offered freely, rational investors would take the above factors into account, resulting in the niche clientele holding the securities, and rendering the ownership restrictions unnecessary.

We present two alternative rationales for why ownership restrictions can be potentially valuable. The first one is that ownership restrictions allow for value enhancement through credible precommitments. To understand this rationale consider that the Indians living abroad clientele is an important one for India. They remit substantial foreign exchange, and can directly or indirectly vote in the political process. By restricting the security to a clientele that an issuer cares about, the issuer is able to precommit to treat this clientele more favorably than other investors in an event of default. That is, ownership restrictions ensure that other investors do not free ride (see Grossman and Hart, 1980) on the favored clientele. Absence of ownership restrictions can lead to multiple classes of investors (due to potential free-riding) and dilute an issuer's incentives to renegotiate efficiently in the potential default states. (4) Thus, ownership restrictions help an issuing firm to overcome this free-rider problem and make an effective precommitment to renegotiate efficiently in an event of default. More generally, where an investor clientele has a broader relationship with the firm, one that has dealings that extend beyond its current investment in the issuer's securities (e.g., the investor is a dependable provider of past and future capital and values the collateral more), the issuing firm is able to credibly precommit to an efficient ex-post renegotiation by issuing securities exclusively to that investor clientele. This rationale is somewhat similar to loans made by the mafia, which are invariably repaid as the cost of non-repayment can be very high (e.g., loss of a leg). By taking loans from a clientele that is critical for continued success of a business, such as the mafia (or the Indians living abroad in our context--See Section III.C for details), there is an implicit ex-post commitment to repay the debt which translates into higher prices ex ante.

Thus, we argue that ownership restrictions enhance value since they enable an issuer to precommit to renegotiate efficiently in the potential default states (as discussed above, by eliminating incentives to free-ride by other investors), thereby circumventing the deadweight costs of prolonged negotiations, particularly when a security is restricted to a homogenous clientele that values the underlying collateral higher than other investors.

A second rationale is that ownership restrictions can result in a transfer of value from other securities. The reason why this occurs is that ownership restrictions influence the priority structure of claims (and indirectly affect the value of collateral), effectively making the restricted securities implicitly senior to the unrestricted securities. This can result in a transfer of value from unrestricted securities to restricted securities.

We empirically test to see if the transfer of value explains the yield differential. Specifically, we test for an implicit transfer of wealth from the existing bond holders to the new bond holders by conducting an event study of the effect of the issuance of the restricted bonds on prices of the unrestricted bonds. One needs to be careful here because such an effect might also come from a restricted debt capacity of the issuer, and of the sovereign nation, so that any new issue of debt securities leads to a decline in the pricing of existing debt securities. Hence, we also check if there is a differential effect between the issuance of new restricted bonds versus new unrestricted bonds on the prices of existing unrestricted bonds. We find a significantly higher price decline for the former case, i.e., for the issuance of new restricted bonds. This is consistent with a transfer of wealth to the holders of restricted bonds from the holders of unrestricted bonds of other Indian firms.

However, we find that some, but not all, of the yield differential is explained by value transfer associated with the implicit higher seniority of the restricted bonds. This suggests that ownership restrictions also enhance value potentially through lower renegotiation costs (since they circumvent the deadweight costs of prolonged negotiations). We also examine whether our results can be rationalized by alternative explanations, such as a higher perceived credit rating, different measures of credit rating, (5) market segmentation, (6) commissions, and taxes. We find that our results are robust to controlling for these alternative explanations.

In summary, we find evidence in support of both the enhancement of value and the transfer of value (from holders of unrestricted securities to restricted securities). Our evidence suggests that firms can benefit from designing securities with ownership restrictions, where securities are offered exclusively to niche clienteles who value them the most. A natural extension of the evidence contained in this experiment is that issuers from other emerging market countries such as China, Israel, and Korea could bypass traditional underwriting routes to take advantage of their large expatriate populations by devising securities that get them higher prices (and lower yields). More generally, firms with niche clienteles where the investor clienteles have a broader relationship with the firm (such as, also being customers or suppliers) can benefit from issuing securities with ownership restrictions. Overall, our analysis shows the wider ramifications of ownership restrictions than suggested in the literature, as an integral part of security design, in lowering (rather than raising) the cost of capital for the issuing firm.

Our article contributes to the literature on foreign ownership restrictions by showing that ownership restrictions can sometimes be value enhancing, whereas the extant literature largely shows that securities with ownership restrictions trade at a substantially lower price than comparable securities without restrictions.

The remainder of the article is organized as follows. Section I outlines our data and sample selection. Section II describes the measurement of yield differentials, along with some robustness checks. In Section III, we present an economic rationale for why some investors are willing to pay more than others for a security and whether the issuing firm can benefit from restricting the offering to them. Section IV empirically tests an implication of restricting the ownership of securities, namely whether there is a transfer of wealth from holders of unrestricted securities to holders of restricted securities. Section V concludes.

I. Data and Sample Selection

To examine the role of ownership restrictions in the security design problem, we conducted an indepth analysis of a natural experiment: multiple events of capital raising by an emerging market company with ownership restrictions, namely $4.2 billion of Resurgent India Bonds and $5.5 billion of India Millennium Bonds offered by India's largest bank, State Bank of India, exclusively to Indians living abroad at approximately 150 basis points below comparable benchmarks.

We collected necessary data to confirm whether there is a significant yield difference between these bonds and comparable benchmarks, and additional data to test for sources of this yield differential. We obtained the data for our empirical analysis from several sources, such as the Securities Data Company's Global New Issues Database, the International Finance Corporation Emerging Markets Factbook, Datastream for historical price and yield data of bonds and bond indices, Moody's website for credit ratings, Dow Jones News Service for assessing credit outlook, Federal Reserve Bank of Chicago's web site for current and historical interest rates, and the websites of the Reserve Bank of India and the State Bank of India for information on Resurgent India Bonds and India Millennium Bonds.

Our sample selection procedure was as follows: First, we extracted the fixed-rate US dollar denominated non-convertible debt issues of foreign issuers from emerging markets (listed in the International Finance Corporation Emerging Markets Factbook) from the Securities Data Company's Global New Issues database that have a maturity of at least one year at the time of offering of the restricted bonds (i.e., Resurgent India Bonds or India Millennium Bonds). Second, we obtained price and yield information of these comparable sovereign and corporate bonds from Datastream. Third, we obtained Moody's credit rating (7) for Resurgent India Bonds, the India Millennium Bonds, and for the comparable bonds at the time of offering of the Resurgent India Bonds and the India Millennium Bonds. In addition, we incorporated additional information about the credit outlook on the issuer and whether the issuer's credit rating was under review for a potential upgrade or downgrade by searching Dow Jones News Services during the 12 months prior to the Resurgent India Bond or Millennium India Bond issue dates. Finally, to obtain yield spreads, we subtracted the yield on the Treasury of comparable maturity obtained from the Federal Reserve Bank of Chicago's web site.

A. Variables

We first test if there is a yield differential between the restricted securities (i.e., Resurgent India Bonds, and India Millennium Bonds) and the unrestricted securities (i.e., comparable bonds). Our main variable of interest is therefore YIELD SPREAD, defined as the ex ante yield of a debt security minus the ex ante yield of a US Treasury security of comparable maturity, measured in basis points. The independent variables for the regression results in Section II.C are as follows:

CREDIT RATING: Stands for a set of comprehensive credit rating dummy variables (B3, B2, B1, Ba3, Ba2, Ba1, Baa3, Baa2, Baa1, A3, A2, Aa3) based on Moody's comprehensive credit rating. (8) For example, Ba1 is a dummy variable which is one if Moody's comprehensive credit rating for the issue is Ba1. The dummy variable is zero otherwise.

MATURITY: The maturity of a debt issue measured in years at the time of offering of the Resurgent India Bonds or the India Millennium Bonds.

EXCHANGE: A dummy variable that takes a value of one ifa debt issue is traded on an exchange, and zero otherwise.

SOVEREIGN: A dummy variable that takes a value of one if a debt issue is a sovereign debt issue, and zero otherwise.

RESTRICTED: A dummy variable that takes a value of one for the Resurgent Indian Bond issue and for the Indian Millennium Bond issue, and zero otherwise.

B. Discussion of Variables

The economic rationale for using these variables is as follows: credit rating of a debt issue is clearly important and one would expect lower-credit rated issues to have higher yield spreads. Maturity is another variable potentially affecting yield spreads. In particular, if the probability of default increases with debt maturity (see Flannery, 1986) then we should expect to see higher yield spreads with longer maturity issues. A debt issue listed on an exchange is more liquid and is associated with more public information, and one would expect an exchange-listed debt issue to have...

NOTE: All illustrations and photos have been removed from this article.




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