The Case: Repackaging Debt

Part A

Scot Bank has been given the opportunity to buy a large quantity of US dollar-denominated bonds issued by Scottish Energy Enterprises (SEE), a triple-B rated British utility company. The total number of bonds would amount to a principal amount of $100 million — but the bonds are currently trading in the market at a discount to par.1

The bonds carry a fixed annual-pay coupon of 6.0 per cent and have exactly five years to maturity —so the first coupon you will receive from buying the bonds is one year away .  Hence, there is no accrued interest to worry about.

The bonds are being offered to Scot Bank at 84.837 per cent of par. At this price, the yield- to-maturity on the bonds is 10 per cent per year.

SEE is a long-standing customer and the bank has an available line of credit for the principal amount of the bonds. Unfortunately, Scot Bank, although interested in the opportunity to   invest in the bonds would want to hold a floating rate asset, not a fixed-coupon bond.

However, the Lightning Investment Bank (LIB) has offered to repackage the bonds for Scot Bank as synthetic floating rate notes via a special purpose vehicle (SPV).

The deal is as follows: Scot Bank will provide $100 for each bond purchased and will receive the SFR (secured floating rate), as the floating rate, plus a 20 basis points spread (0.20 per    cent) over the reference rate (SFR) for the five years, plus a repayment of the $100 principal at maturity. These floating rate payments will take place at the end of each year (i.e., annually) to match the payments of the bond’s coupon interest and up to and including the final maturity at the end of year 5.

The terms and conditions in the US dollar interest-rate swaps market are given below:

Par Swaps Curve

Par swaps rate              9.50%          9.59%         9.62%          9.69%             9.70%

against SFR

SFR: Secured funding rate (the reference rate for the floating side of the swap) Swap interest rates are annual pay, as is the bond

Questions for Part A

1.   Briefly explain why Scot Bank would wish to hold a floating rate asset issued by SEE rather than the fixed rate bonds.

2.   Analyse the synthetic floating rate note offer for “value” . That is, can it be considered a  “fair value transaction” . In doing so, explain and show how the cash flows of the transaction add or do not add up . In doing this, you might like to briefly comment on the following issues/questions:

a.   Take into consideration when undertaking your analysis that Scot Bank is not a sophisticated user of derivatives.

b.   Is the transaction a reasonable one from Scot Bank's perspective or is the Lightning Investment Bank using its superior knowledge of financial engineering and derivatives to exploit the bank?

Note no transaction will be entirely at fair value since there will be transaction costs and the provider (LIB) will expect to be remunerated for their efforts, if not charging a fee. You may wish to comment on whether any deviation from fair value represents a reasonable structuring fee.

c.    Is any mispricing (i.e., deviation from fair value) significantly above what one might expect, given the point in b. and what are the advantages/disadvantages of Scot     Bank entering into the synthetic being offered by Lighting Investment Bank?

d.   Explain and show how LIB has structured the deal using your calculations to demonstrate the way the structure is put together . (Remember: follow the cash!)

Marks for Part A: 70

Part B

Assume that exactly two years have now passed.

Between  the  initial  transaction  in  Part  A  and  now  Part  B,  Scot  Bank  has  reviewed  its investments and would now like to unwind the synthetic floating rate note created from holding SEE dollar bonds and where the SPV then sells-off the bonds. At this point, the bonds, with exactly 3-years to maturity, are trading at 93.18 in the market.

Interest rates have fallen, and the new interest rate par swaps yield curve is as given below:

New Par Swaps Curve

Maturity

1 Year 2 years 3 Years

Make sure you show how you arrived at the result (i.e., how the solution to the problem was arrived at) as this is most definitely a core part of the assignment.

Working with a spreadsheet and using this to present your results is fine. Just don’t give me the decimal dust. Work in millions to two decimal places (Excel will do the necessary rounding) and seek to report your findings in the way the market speaks. It should be basis  points for fractions of a percent and not decimals (0. 15% = 15 basis points).

There is no set report format, but it is good practice to plan the written document in the form  of a report. After all, this is how you will have to report your findings if you were writing this in a business setting!

Consider the layout and the presentation of the tables. Tables should be properly notated and described, if necessary. Think how the whole report will look to the reader, so consider the   impression it gives to the recipient. You should be aiming for a professional look to your report.

Note the report will be “read” electronically, so you need to take that into account in how it “looks” when read in this way.

Happy learning!

Examples of Analysts’ Reports

Below are some examples, based on common stocks, to show you the “professional” approach to short report formats used in financial services. (Alas, I couldn’t find similar ones for swaps.)

Now I am not suggesting you slavishly follow the format for these reports but use these      examples to inspire yourself towards providing me with a professional-looking assignment.

Key points to note about these reports (which I make in my brief):

•   Their brevity. None of these “one-pagers” use a lot of words to explain their point-of- view.

•   They make use of tables and charts whenever possible to tell the story. Note how clear and well laid out they are without decimal dust and other clutter.

•   A lot of detail the reader knows is omitted and only the key information is given. As per the brief, you can do this. I do not need to know what a swap is, nor what the floating rate is and so on.

• They get to the point straightaway and highlight conclusions immediately.

Note: You can/should ignore both branding and contacts in your versions.