The Case: Repackaging Debt
Part A
Scot Bank has been given the opportunity to buy a large number of US dollar-denominated bonds issued by Scottish Energy Enterprises (SEE), a triple-B rated British utility company. This would amount to a principal amount of $100 million—but the bonds are currently trading in the market at a discount.
The bonds carry a fixed annual-pay coupon of 6 per cent and have exactly five years to maturity—so the first coupon you will receive from buying the bonds is one year away. There is no accrued interest.
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.
Unfortunately, Scot Bank, although interested in the opportunity, 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 LIBOR, as the floating rate, plus a 20 basis points spread (0.20 per cent) over the reference rate 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 on the bond 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
Maturity
1 Year
2 years
3 Years
4 Years
5 Years
Par swaps rate against LIBOR
9.50%
9.59%
9.62%
9.69%
9.70%
LIBOR: London Interbank Offered Rate (the reference rate for the floating side of the swap)
Swap interest rates are annual pay
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. 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. 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?
b. Take into account in your thinking that Scot Bank is not a sophisticated user of derivatives.
c. Is any mispricing (i.e. deviation from fair value) significant 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. (Remember: follow the cash!)
[Part A: 70%]
Part B
Assume two years have now passed. Interest rates have dropped and the new interest rate swaps curve is as given below:
New Par Swaps Curve
Maturity1 Year2 years3 YearsPar swaps rate against LIBOR8.25%8.38%8.45%
Between the initial transaction in Part A and 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 sell-off the bonds. At this point, the bonds, with exactly 3-years to maturity, are trading at 93.18 in the market.
Questions for Part B
a. What will be the new value of the synthetic floating rate note package and will Scot Bank be able to unwind the transaction without incurring a loss?
b. At what price must the SPV sell the bonds to break even, so that ScotBank does not incur a loss of principal?
c. Explain what has to happen at this point for all the cash flows to net off correctly and ensure that ScotBank does not incur a loss of principal. (Remember: follow the cash!)
[Part A: 30%]
[Total A and B: 100%]
Some Thoughts on Writing the Assignment
As detailed in the brief above, I am not expecting a long report on this assignment. So, keep it short and to the point: It is not a large part of the course’s assessment.
The maximum word count (excluding tables and references) is 800 words.
You will need to plan what to say, given the length/word count limitation. Use the exhibits to provide the technical detail and write to explain/justify the results you obtain.
As you realise, this is an exercise in financial engineering using swaps, so what I am looking for is your ability to understand and calculate the transactions involved and explain the results/ processes involved. Therefore, in a sense, what I am seeking is a diagnostic analysis, with all the cash flows accounted for—but that said, there is no single pre-set way of addressing the topic.
Make sure you show how you arrived at the result (i.e. how the solution to the problem was arrived at) as this is 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 might have to report your findings if you were writing this in a business setting.
Consider the layout and the presentation of the tables. 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.
Part A
1)
Par swaps curve shows that as the term increases, the swaps rate rises, so Scot Bank may expect interest rates to rise in the future, so it is more advantageous to charge floating interest rates. Scot Bank may need to pay variable interest rates for some of its liabilities, so it hopes to charge variable interest rates to hedge interest rate risk.
2)
5-year par swaps rate against LIBOR is 9.70%, so 5-year par swaps rate against LIBOR+0.2% is 9.90%. Scot Bank can get LIBOR+0.2% floating rate from the repackaged bond, which is equivalent to a fixed interest rate of 9.90% per year. Since Scot Bank initially pays $100 and receives a principal of $100 after 5 years, 9.90% is the yield-to-maturity of the repackaged bond, which is less than 10% yield-to-maturity of the SEE bond. The transaction is not a reasonable one from Scot Bank's perspective.
If not consider transaction costs, mispricing exists, because 9.90% of yield-to-maturity is significantly lower than 10%. If the efforts of Lighting Investment Bank for the structured the deal are taken into account, this yield-to-maturity gap may be not significant.
Scot Bank may be willing to enter into the synthetic being offered by Lighting Investment Bank. This transaction may help Scot Bank achieve integrated asset-liability management, thereby reducing the interest rate risk faced by the bank. Scot Bank may have more information than the market, so it is reasonable to expect that interest rates will rise sharply in the next few years, thereby obtaining more interest payments than the SEE bond. But the disadvantage of accepting the synthetic is that Scot Bank must pay a fair value concession.
The SPV of Lighting Investment Bank charges a fixed interest rate and pays a floating interest rate to structure the deal. Lighting Investment Bank initially collects $100 from Scot Bank and purchases SEE bonds. Within 5 years, The SPV regularly charges a fixed interest rate of 6% and pays LIBOR+0.2% to Scot Bank. After 5 years, the SPV will receive $100 and pay Scot Bank $100, with the remaining $17.87 as compensation for the higher interest paid in the previous period. During this period, 0.1% of the yield will be obtained by Lighting Investment Bank.
SPV cash flow:
Year
Receive
Payment
Net cash flow
0
$100
-$84.837
$15.163
1
$6
$100*(LIBOR+0.2%)
$6-$100*(LIBOR+0.2%)
2
$6
$100*(LIBOR+0.2%)
$6-$100*(LIBOR+0.2%)
3
$6
$100*(LIBOR+0.2%)
$6-$100*(LIBOR+0.2%)
4
$6
$100*(LIBOR+0.2%)
$6-$100*(LIBOR+0.2%)
5
$106
$100*(1+LIBOR+0.2%)
$6-$100*(LIBOR+0.2%)
Part B
a)
Corresponding to the current floating interest rate of LIBOR+0.2% is the swaps rate of 8.65%. The new value of the synthetic floating rate note package must make the yield-to-maturity of 8.65% with a face value of $100 and a fixed interest rate of 9.90%. Thus the new value=$103.18. Scot Bank will be able to unwind the transaction without incurring a loss.
b)
The cash outflow of SPV in the next three years is $103.18. In order for Scot Bank does not incur a loss of principal, Scot Bank must receive $100, which is $3.18 less than the present value of note package future cash flows of $103.18. The SPV can sell bonds at a price lower than the market price of $3.18, which means breakeven price should be $90.
c)
The SPV should pay all the cash accumulated in the previous two years and the cash obtained from selling bonds to Scot Bank. The total cash amount should not be
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