It’s a problem that has baffled financiers for decades: Why don’t U.S. investors buy shares in companies overseas? As things stand, Americans hold only 9 percent of equity investments in foreign companies, and yet foreign stocks represent 51 percent of the world market.
Nobody knows why this home bias exists. “It could be lack of familiarity with overseas markets, language and cultural issues, or barriers to international investment–it’s unclear,” observes James Wardlaw, a managing director at Merrill Lynch.
A new research report released earlier this year could shed some light. “Corporate Governance and the Home Bias,” by Lee Pinkowitz and Rohan Williamson, both of Georgetown University, and René Stulz of The Ohio State University, shows that Americans aren’t nearly as biased as they seem. In fact, their findings suggest that, au contraire, foreign markets are keeping U.S. investors at bay.
The key to their conclusion is the presence of “controlling shareholders”–investors who own big chunks of a company’s shares that they won’t sell unless they’re paid compensation for their loss of control. These shareholders limit the number of shares available for trading.
While the U.S. equity market accounts for 49 percent of the value of the world market, it makes up almost 60 percent of the world’s free-floating shares. “Taking into account the role of controlling shareholders has the effect of reducing (but not eliminating) the home bias of U.S. investors,” notes the report.
On average, say the authors, 32 percent of shares worldwide are unavailable for trading. The country-by-country differences are vast. The United States has the lowest fraction of closely held shares–7.9 percent.
Total amount of closely held shares limits U.S. ownership.
% of market cap closely held
% of U.S. investor portfolio
% of world market
Source: Pinkowitz, Stulz, and Williamson
Good News for Coco Buffs
Who dares, wins. Companies issuing contingent convertible bonds–or “cocos”–over the past two years took a risk that the very tax benefits that made these debt instruments so attractive might prompt the Internal Revenue Service to outlaw them. Instead, in a June ruling so favorable it surprised even coco developers, the IRS gave the hybrid securities its unconditional blessing.
Historically, the tax code has allowed companies to deduct only the stated interest rate of a convertible bond–which is low because investors reap a second payout when the bond converts to equity. The IRS excludes convertibles from other types of contingent debt, for which a much higher “comparable yield” can be deducted.
That exclusion was circumvented by coco developers like Merrill Lynch, which tacked on extra contingencies–such as additional interest payments triggered by certain price movements of the underlying stock–to traditional convertibles. Although these new contingencies can be “relatively insignificant in amount or in likelihood of occurrence,” says the IRS, the agency ruled that they changed the bond enough to let it qualify for the larger deduction.
“I wasn’t expecting this (ruling),” says Dan Zucker, a partner at law firm McDermott, Will & Emery, which has advised on the issuance of cocos. “I was surprised not only that (the IRS) said something about it, but that what they said was so favorable.” In fact, the IRS also invited public comment on whether the comparable-yield calculation should also be allowed for straight convertible bonds.
Until that happens, newly approved cocos could be destined to completely replace less tax-friendly convertible bonds. But, notes Zucker, cocos don’t typically sell for a premium over convertibles. That means issuing companies must eat the risk of the added contingencies. In a down market, that’s already come back to bite some companies.
There’s another drawback to cocos: while issuing companies can deduct more interest than they pay, coco holders must also book an equal amount of phantom income and pay taxes on it. Fortunately, that phantom income is not a problem for the primary purchasers of cocos–tax-
exempt institutional investors, as well as those that use the mark-to-market method of accounting.