Recently, there are some studies about the influence of corporate governance mechanisms on bond rating and yield done by the investigators such likes the impact of default risk, risk between the management and providers of capital, misallocation of funds and so on. It is very important to view these valuable papers because it guides us in our study as well to do better and learn from previous error. In our study on the affects of bond yield, we compare the effectiveness of alternative methods done by the previously papers so that we can proceed our study appropriately and systematically. Thus, we will find out some relevant research reports, journals, books, reading materials and so on from different ideals and expertise about the bond yields and it ratings. The following are divided into few sections. The first section discussed the general theories that related to corporate governance and yields and bond ratings. Next, empirical model used in previous studies are discussed. In the third section it discussed the empirical evidence on the effect of corporate governance on bond yields and bond ratings. These are several general ideas that were obtained from authors of prior studies about the corporate governance, yields, and bond ratings. All of the idea from prior study will lead in this study and result can be compared since this study is about Malaysian listed companies while some other studies are about other countries. Lastly, it concludes the literature reviews in overall. Each of the literature review are summarize into table form on the end of this chapter.
2.2 Theoretical Framework
“Corporate governance encompasses a broad spectrum of mechanisms intended to mitigate agency risk by increasing the monitoring of managements’ actions, limiting managers’ opportunistic behavior, and improving the quality of firms’ information flows” (Zulkufly and Hafiz, 2010). Bhojraj and Sengupta (2003) states “debt yield and ratings are essentially determined by the probability that the firm will not be able to meet its obligations and by the degree of protection afforded to the lenders in such an event”. Norliza et al. (2009) study states that there are three type of relationship between yields and bond price which are (1) coupon yield which referred to interest paid to the bondholder as a percentage of bond par value, namely coupon rate of the bond; (2) current yield which being measured by the annual coupon income divided by bond’s market price; and (3) yield to maturity (YTM) which provide more comprehensive measurement of the bond or return by estimating the total amount of income for the entire period of bond holdings.
Bhojraj and Sengupta (2003) in their study calculated approximately the effect of corporate governance on yields and bond ratings over the period of 1991-1996 with 1005 samples of industrial bond which collected from Warga Fixed Income Database. There are two general model functions have been applied in his study which are: Bond Ratings = f (governance variables, control variables); (1) Bond Yields = f (governance variables, control variables). (2) Model one above is use for testing the effect of governance variables on bond ratings and model two is use to testing the effect of corporate governance variables on bond yields. The governance yields and bond ratings variables in Bhojraj and Sengupta (2003) study are as follow: INST the percentage of the company’s common stock held by institutions. INST have positively related to bond ratings but negatively related to bond yields. Result is consistent with INST having a favorable impact on default risk. OUTDIR the percentage of the board of directors who are not also officer of the firm. Result is consistent with OUTDIR having a favorable impact on default risk. OUTDIR have positive relations with bond ratings and negatively related to bond yields. INST5 the percentage of the company’s common stock held by the five largest institutional owner of the firm. INST5 have negative relations with bond ratings and positively related to bond yields. BLOCK the total percentage of company’s stock held by institutions owning 5% or more of the company’s stock. BLOCK have negative relations with bond ratings and positively related to bond yields. The control variables are as follow: YIELD yield to maturity on bond issue minus yield to maturity on government Treasury bond of similar maturity. RATING ordinal variable taking on value from 1 to 6 representing Moody’s bond rating B or below, Ba, Baa, A, Aa, and Aaa, respectively. LSIZE log of the size of issue. LSIZE have inversely related to bond yields and positively associated with credit ratings. MATUR years to maturity. Bond with longer maturity is expected to have a higher yields and lower ratings because of their greater risk exposure. LSIZE have negatively related to bond ratings and positively related to bond yields. CALL the ratio of the days to first call dividend by the days to maturity. 1 represented no call while 0 represent callable from the date of issue. CALL will negatively associate with bond yields and positively associated with Moody’s ratings. SENIOR 1 if the debt is senior and 0 otherwise. Senior debt is expected to be associated with lower yields and higher bond ratings. SENIOR have positively related to bond ratings and negatively related to bond yields. SINK 1 if the debt has sinking fund and 0 otherwise. Sinking fund provisions reduce default risk so that this should be negatively associated with bond yields and positively associated with bond ratings. DE book value of long term debt divided by the market value of common equity at the end of year t. firm with higher debt to equity ratio are expected to have a higher yields and lower ratings. DE have negatively related to bond ratings and positively related to bond yields. MARGIN income before extraordinary items divided by total assets of year t. firms with higher profit margin are expected to enjoy lower yields and higher ratings. MARGIN have positively related to bond ratings and negatively related to bond yields. ASSET total assets at the end of year t. Larger firms are expected to enjoy a lower YIELD and higher RATING because of their lower market risk. ASSET have positively related to bond ratings and negatively related to bond yields. MKBK market value of common equity divided by the book of common equity at the end of year t. firms with higher MKBK represented high growth firms that could be associated with greater risk. This suggests MKBK have a positively associated with bond yields and negatively associated with credit ratings. CUMRET cumulative daily stock return over year t; CUMRET capture the stock price performance of the firm over a period. This would be positively associated with future expected cash flows of the firm, which suggest a lower default risk. BETA market beta calculated using daily stock returns over period t; BETA captures the systematic risk of the firm, which is expected to be positively associated with default risk. This suggest that BETA would positively associated with YIELD and negatively associated with RATING. Bhojraj and Sengupta (2003) study using few tests which are Ordered Probit Regression, where it used ratings as dependent variable; next, they used OLS regression to test the effect of corporate governance mechanisms on bond yields; 3SLS regression also been used and the result show that YIELD in the INST regression is negatively and statistically significant at 0.01 level. On the other hand, Norliza et al. (2009), also have study regarding yield spreads but macroeconomic variables such as Consumer Price Index (CPI), interest rate (IR), Industry Production Index (IPI) and Kuala Lumpur Composite Index (KLCI) have been used. Their data consists of monthly observation since January 2001 to December 2008, with a total 149 Malaysian Government Securities data and 238 Corporate Bond (CB) data. All of the data are collected from Economics Report and the Bank Negara website. The model of their study is as follow: (3) Result from the long run equation show that there is negative relationship between Corporate Bond yield spread and KLCI, IPI and IR and positive relationship between Corporate Bond yield spread and CPI. On the other hand, result from granger causality show that the relationship suggests that the movement of KLCI, CPI and IPI can be used as a useful and reliable indicator to predict IR. The presence of unidirectional causality effect from IPI to corporate bond implies that the economic growth as measured by IPI Granger cause yield spread. Lastly, Ziebart and Reiter (1992) also study regarding bond yields and bond ratings. There study consists of 189 new industrial binds issued between February 1981 and February 1985. The result for their study show that the used of simultaneous equation modeling result in the ability to conclude that financial information affects bond ratings, and bond ratings directly affect the bond yields, that financial information indirectly affect bond yields through the link to bond ratings, and that financial information also directly affect bond yields. The model use in Ziebart and Reiter (1992) study are as follow: (4) (5) The variables used to proxy for issue characteristics, macroeconomic conditions and financial information with the explanation of their expected signs of the model are the following: (4.1) (5.1) OFYLD offering yield on the new issue RATE Moody’s or Standard & Poor’s bond rating Issue characteristics: SFMAT Years to maturity (adjusted for sinking fund provision). Have positive relations with OFYLD. SF Presence of a sinking fund agreement (0,1). Positively related to OFYLD. SUB Subordinate status (0,1). Positively related to OFYLD and negatively related to RATE. LPER Natural log of term of call or refunding protection. Negatively related to OFYLD DFYLD Difference between offering yield and the yield to first call or refunding date. Negatively related to OFYLD. DISC original issue discount (0,1). Positively related to OFYLD. ISSUE Natural log of issue size. Negative relationship with OFYLD. Macroeconomic conditions: MOOD Index of consumer sentiment. Have a negative relation with OFYLD. TYIELD Average level of U.S. Treasury issues with 10-year or longer maturity dates. Have a positive relationship with OFYLD Financial information: BETA Value Line beta. Positively related to OFYLD and negatively related to RATE. COV Interest coverage ratio: interest expense/ income before interest and taxes. Positively related to OFYLD but negatively related to RATE. TO Turnover ratio: net income/total asset. Negatively related to OFYLD but positively related to RATE. DE Debt to equity ratio: long term debt/market value of common equity. Positively related to OFYLD but negatively related to RATE. SIZE Natural log of total assets. Positively related to RATE.
2.3 Empirical Evidence
Concept of corporate governance describe as referring to corporate decision making and control particularly the structure of the board and its working procedure since corporate governance describe as which the government of company; the director is responsible to its electorate; the shareholders (Kim and Rasiah, 2010). Corporate governance also stated as a set of rule and procedure by Kim and Rasiah (2010) where it is use to ensure the managers do their indeed employ by the principles of value based management. Result of Bhojraj and Sengupta (2003) study show that firm with larger institutional ownership enjoy higher bond ratings and lower bond yields after controlling for other potential determinants of ratings and yields. When institutional ownership gets concentrated, firm will face a lower ratings and higher bond yields while when firm have a greater percentage of outside directors on the board are found to have higher ratings and lower bond yields (Bhojraj and Sengupta, 2003). Norliza et al (2009) find that investors with higher risk tolerance may consider increasing their investments in this investment during economic uncertainty such as indicated by increasing CPI and decrease in IPI while during economic turmoil, investor may benefit from higher yield spread due to the increase of risk premium. This study shows that interest rate is one of the major factors that determine bond yield spread. It does also conclude that the higher the yields given by the corporate bonds as a mean to compensate for the instrument’s risk exposure. According to Bhojraj & Sengupta (2003), small changes in debt yields could lead to large shifts in capital allocation, therefore, this study explore the influence of corporate governance mechanism on bond ratings and yield. Governance mechanism can reduce default risk by migrating agency costs and monitoring managerial performance and by reducing information asymmetry between the firm and the leaders (Bhojraj & Sengupta, 2003). Klock et al. (2005) compute bond ratings using a conversion process in which AAA-rated bonds are assigned a value of 22 and D-rated bonds a value of 1. For example, a firm with an A+ rating from S&P would receive a score of 18 (Liu and Jiraporn, 2010). S&P credit ratings are following in Liu and Jiraporn (2010) study because prior research argues that the S&P ratings reflect the overall credit worthiness of the firm. Bhojraj and Sengupta (2003) find that institutional ownership is an important determinant of credit ratings and yield spreads. According to Ziebart and Reiter (1992), yields model typically model the bond yields as a function of macroeconomic conditions, issues characteristics and default measurements; where this default risk usually represented by bond ratings. On the other hand, when governance mechanism reduces the agency risk, firm with stronger governance should be associated with the superior bond ratings and lower yields (Bhojraj and Sengupta, 2003). Besides, their study also proves that governance mechanisms can help to reduce the information risk by inducing the firm to disclose information in a timely manner. Skaife et al. (2006) study proved that weak governance can result in firms incurring higher debt financing costs. While in Sengupta (1998) study find out that there is a negative relationship between firms’ disclosure quality ratings and the cost of debt financing as reflected in realized yields on new debt issues. This also proved by Ziebart and Reiter (1992) where price reactions to the changes of ratings may indicate the market inefficiency or may indicate that the bond rating agency have access to important nonpublic sources of information. Bhojraj and Sengupta (2003) study show that firms with a higher percentage of outside directors on the board and with greater institutional ownership enjoy lower bond yields and higher ratings on their new debt issues. On the other hand, Skaife et al. (2006) study show that firms with stronger shareholder rights have higher share values and enjoy a lower cost of equity capital. Beside, their study also posit that if governance is weak, the firm’s distribution of future cash flows will shift downward relative to what it would be with more effective governance. Ziebart and Reiter (1992) also prove that bond ratings and bond yields are negatively correlated where higher the yields are required by investors to compensate for the risk of investing in the lower rates bonds. Prior studies on corporate governance tend to focus on one attribute of governance, e.g., board independence, as opposed to studying a broad set of governance attributes intended to protect stakeholders’ claims to firms’ resources (Bhojraj and Sengupta, 2003). Germane to bondholder interests, Bhojraj and Sengupta study posit that firms with a greater proportion of outside directors on the board provide better monitoring of management actions. Thus, bondholders face less agency risks vis-a` -vis management. They posit that this, in turn, will lead to higher bond ratings and lower debt yields. Consistent with this conjecture, they find that firms with a higher proportion of non-officer directors enjoy lower bond yields and higher ratings on new bond issues (Skaide et al., 2006). Sulong and Nor (2010) study is motivated to provide an evidence on the effectiveness of monitoring and control mechanisms through dividend, types of ownership structure, and board governance on firm value during post-reform period in Malaysia. Therefore, it can be said that corporate governance mechanisms exist to protect and enhance the interests of shareholders, as well as to protect the interests of minority shareholders against managers and controlling shareholders (Sulong and Nor, 2010). Ponnu (2008) affirmed that companies with better corporate governance have a better operating performance than those companies with poor corporate governance which was concurrent with the view that better governance firms might have more efficient operations, resulting in higher expected returns and therefore, good corporate governance helps to generate investors goodwill and confidence. “Our direct measure of the cost of bond financing is Yield Spread, defined as the difference between the at-issue yield spread of the bond and a U.S. Treasury bond with comparable maturity, measured in basis points. This measure has been widely used in the literature to capture the ex-ante cost of debt” (Liu and Jiraporn, 2010; Bhojraj and Sengupta, 2003). In this paper, they attempt to investigate how bondholders assess the quality of the bond issues given that they can observe the power structure of the issuing firms. The separation of roles between CEO and board Chairman also has been recommended by the MCCG 2001. In contrast to the majority of prior studies that mostly focus on developed markets such as US and UK, but Sulong and Nor (2010) study are utilizes the non-financial Malaysian listed firms’ panel dataset for a large firms sample during the post-reform period taken by Malaysian capital market regulators. Furthermore, the firms listed on Bursa Malaysia are relatively smaller and more growth oriented compared to those in the developed market. Koehn and Ueng (2005) study find out that companies that have a weaker boards will performed poorly and this will due to less profitable and reported earning with a higher volatility than firm that characterized as having a stronger corporate governance. They also stated out that institutional investors believed that best practice of corporate governance will benefits shareholders over a long haul. This also proves by Bushman study who stated that governance is posited to get weaker as the proposition of inside directors increases. The weaker position of governance will give a greater managerial power over the boards which lead to a higher incidence of backdating executive stock options. On the other hand, in Liu and Jiraporn (2010) study, they show that by controlling CEO characteristic, CEO pay slice have a negative effect on credit ratings and positive effect on yield spreads. They find out that institutional ownership is the most important tools to determine the credit ratings and yield spreads. Hence, they conclude that the stronger CEO power is associated with a higher cost of bond financing and lower credit ratings. Overall, CEO power will has a significant yield increasing effect on the cost of bond financing (Liu and Jiraporn, 2010).
2.4 Concluding Remarks
Based on overall review that been done, many author are using panel data since few country or company and few years been study together to find out the effect of corporate governance on bond yields and bond ratings; relationship between bond yields and bond ratings; institutional relationship with bond yields and bond ratings. The tests that have been use in almost all of the study are Correlations, OLS regression, descriptive statistic and causalities tests. Finding from most of the researchers are almost the same since most of the variables are being use in few study are the same. Mostly of the review findings show that bond ratings and bond yields have an inverse relationship where when bond ratings are high, bond yields will be lower. Since corporate governance become more popular in today business world, therefore, there are many researcher studies about corporate governance in Malaysia which started after the Asian Financial Crisis in 2007 due to weak corporate governance in the corporations. Although this is the case, but half of the literature review in this study are based on other countries study like United States to have a similar view on corporate governance between Malaysia and other countries.