Structures Notes is a beyond traditional securities. Callable, putable, and convertible bonds are considered traditional securities, as are other similar structures such as extendible and retractable bonds [Note: An extendible bond grants the issuer the right to extend the redemption date beyond the stated maturity date. A retractable bond grants the bondholder the right to redeem on a date prior to the original maturity date]. There are bonds with embedded options that have much more complicated provisions for one or more of the following: interest rate payable, redemption amount, and timing of principal repayment. The interest or redemption amount can be tied to the performance or the level of one or more interest rates or non-interest rate benchmarks. As a result, the potential performance (return and risk) of such securities will be substantially different from those offered by plain-vanilla bond structures. These securities are popularly referred to as “STRUCTURED NOTES”.
Through this post I discuss about STRUCTURED NOTES; what is structured notes, how is it structured, how it works, how to create structured notes, why structured notes is interesting. I also revealed two types of structured notes [Interest-Rate Linked Structured Notes and Equity-Linked Structured Notes], how they work, how they are compare to traditional securities. They come with formulas, light calculation examples and case examples, of course. But, before them, let’s do a quick overview how a basic plain-vanilla bond is structured. Follow on…
Plain-vanilla Bond Structure
For a plain-vanilla bond structure:
- the coupon interest rate is either fixed over the life of the security or floating at a fixed spread to a reference rate; and
- the principal is a fixed amount that is due on a specified date. There are bonds that have slight variations that are common in the marketplace.
A callable bond may have a redemption date that is prior to the scheduled maturity date. The option to call the bond prior to the maturity date resides with the issuer; the benefit of calling the issue depends on the market interest rate at which the callable bond issue can be refinanced.
Similarly, a putable bond has a maturity date that can be shortened, but in this case the option resides with the bondholder; if the market rate on comparable bonds exceeds the coupon rate, the bondholder will exercise.
A convertible bond typically has at least two embedded options. The first is the bondholder’s right to convert the bond into common stock. The second is the issuer’s right to call the bond.
Note: Some convertible bonds are also putable.
What is Structured Notes [How is it Structured?]
In a survey article on structured notes, Telpner defines structured notes as:
Fixed-income securities—sometimes referred to as hybrid securities that present the appearance of fixed-income securities—that combine derivative elements and do not necessarily reflect the risk of the issuer [Joel S. Telpner, “a survey of structured notes,” The Journal of Structured and Project Finance (Winter 2004), pp. 6–19.7]. Here the key element is that the issuer is not necessarily taking on the opposite risk of the investors.
In their book on the structured notes market, Peng and Dattatreya write, “structured notes are fixed income debentures linked to derivatives”. They go on to say:
A key feature of structured notes is that they are created by an underlying swap transaction. The issuer rarely retains any of the risks embedded in the structured note and is almost hedged out of the risks of the note by performing a swap transaction with a swap counterparty. This feature permits issuers to produce notes of almost any specification, as long as they are satisfied that the hedging swap will perform for the life of the structured note. To the investor, this swap transaction is totally transparent since the only credit risk to which the investor is exposed is that of the issuer [Peng and Dattatreya, The Structured Note Market, p. 2].
In this definition, the focus is not on the issuer selling a debt instrument with derivative-type payoffs to investors, but the issuer protecting itself against the risks associated with the potential payoffs it must make to investors by hedging those risks. That is, the upside potential available to investors in a structured note does not reflect risk to the issuer.
While Peng and Dattatreya say that this can be done with a swap transaction, any other derivative can be employed to hedge the risk faced by an issuer [Note: a swap is a transaction that results in the exchange of a stream of cash lows among parties. For example, a swap may involve two parties: one that has a fixed payment cash low stream and another that has a floating (that is, variable) cash low stream. These parties can agree to exchange these cash low streams in a swap agreement].
A structured note can be issued in the public market or as a private placement or a 144a security. It can take the form of either commercial paper, a medium-term note, or a corporate bond. The issuer must be of high credit quality so that credit risk is minimal in order to accomplish the objectives that motivated the creation of the structured note.
Issuers include highly rated corporations, banks, and U.S. government agencies. Because credit risk increases over time, the type of issuer and the form of the security are tied to the planned holding period of the investor.
Below table provides a summary of the relationships among the maturity profile of the investor, the typical form of the debt instrument, and the typical issuer.
Maturity Profile Factor, Typical Form of Instrument, and Typical issuer
Maturity Typical Form of Instrument Typical Issuer
Under 1 year Commercial paper A1/P1 rated corporations
1 to 3 years Commercial paper, bank note, banks, corporations
Greater than 3 yrs Corporate bond, medium term U.S. government agencies
Note: Adapted from Scott Y. Peng and Ravi Dattatreya, The Structured Note Market
(Chicago: Probus, 1995), p. 303.
Why Structured Notes Is Interesting? [Motivation for Investors]
The motivation for the purchase of structured notes by investors includes:
- the potential for enhancing yield;
- acquiring a view on the bond market;
- obtaining exposure to alternative asset classes;
- acquiring exposure to a particular market but not a particular aspect of it; and
- controlling risks.
The potential for yield enhancement was the motivation behind the popularity of structured notes in the sustained low-interest-rate environment.
The ability of issuers to hedge risk using derivatives allowed them to create securities for investors who had a view on the bond market.
For example: a structured note could be created that allowed exposure to a change in the yield curve, the change in the spread between two reference interest rates, or the direction of interest rates (e.g., a leveraged payoff if interest rates declined).
Structured notes that have payoffs based on the performance of asset classes other than bonds allow investors to take views on other markets in which they may be prohibited from investing by regulatory or client constraint.
For example: suppose that an investor who must restrict portfolio holdings to investment-grade bonds has a view on the equity market. The investor would not be permitted to invest in equities. However, by investing in an investmentgrade bond whose payoff is based on the performance of the equity market, the investor has obtained exposure to the equity market. For this reason, some market participants refer to structured notes as “rule busters”.
Finally, a structured note can be used to hedge exposure that an investor may not be able to hedge more efficiently using derivative products.
For example: suppose that an investor is concerned with exposure in its current portfolio to changes in credit spreads. While there are currently credit derivatives that would allow the investor to hedge this exposure, suppose that the investor is not permitted to utilize them. An investor can have an issuer create a structured note that has a payoff based on a particular credit spread. The issuer can protect itself by taking a position in the credit derivatives market.
But what is the benefit of all this customization for the issuer? By creating a customized product for an investor, the issuer seeks a lower funding cost than if it had issued a bond with a plain-vanilla structure.
How do borrowers or their agents find investors who are willing to buy structured notes? In a typical plain-vanilla bond offering, the sales force of the underwriting firm solicits interest in the issue from its customer base. That is, the sales forces will make an inquiry to investors about their needs and preferences. In the structured note market, the process is often quite different.
Because of the small size of an offering and the flexibility to customize the offering in the swap market, investors can approach an issuer through its agent about designing a security for their needs. This process of customers inquiring of issuers or their agents to design a security is called a reverse inquiry.
Three Main Steps in Creating Structured Notes
Peng and Dattatreya describe the three main steps in creating a structured note:
Step-1. Conceptual Stage
In customizing a structured note for a client, the investment banker must understand the client’s motivation. This is the conceptual stage of the process.
I described earlier why investors look to the structured note market for customization. The investor will provide the motivation through reverse inquiry. However, the design of the structure note should consider the possible tax impact on the investor. For example: in the United States, if the note provides protection of the principal, the profits to individual investors are generally treated as ordinary income; if the note does not provide any principal protection, profits on the note may be treated as capital gain income and given preferential treatment if the holding period is satisfied.
The challenge is that while the two extremes are easy to figure out, the tax treatment is not clear in the case of notes with some protection of the principal [Anne Tergesen, “Quirkiest Vehicle on the street“, Business Week, November 20, 2006].
Step-2. Identification Process
In the identification process, the investment banker identifies the underlying components that will be packaged to create the structured note based on the requirements identified in the conceptual stage. This process begins with specifying five customization factors: nationality, rate profile, risk/return, maturity, and credit. The nationality factor specifies the country where the client would like to have some investment exposure.
In the case of structured notes where the underlying is an interest rate, the rate factor determines the directional play (e.g., rising or falling interest rates, flattening or steepening yield curve) that is to be embedded in the structure. The amount of risk to be embedded in the structured note is the risk/return customization factor. Both the maturity and credit customization factors determine the instrument that will be used and the type of issuer as described in the above table.
Step-3. Structuring or construction stage
In the structuring or construction stage, the investment banker gathers the pertinent market data and issuer-specific information. This information includes the target funding cost for the issuer (after underwriting fees) and the desired coupon and principal structure based on information from the conceptual and identification stages. In determining the cost of the structure, recognition must be given to the hedging cost that will be incurred when using the derivative instrument or instruments.
Other specifications of the structured note that may have to be determined will depend on the complexity of the structure. For example, a structure may require that the correlation of the factors driving the price of the underlying instruments in the structure be estimated.
Two Types of Structured Notes
A wide range of structured notes have been created in the market. Here I will discuss only two types:
(1) Interest-rate Structured Notes (more specifically, an inverse floater); and
(2) Equity-linked Structured Note.
While I do not describe the derivative instrument used in the creation of these two structured notes, swaps , the principles are fairly simple to follow.
Type#1. Interest-Rate Linked Structured Notes
The general coupon formula for a floating-rate security (floater) is:
Reference Rate + Quoted Margin
A structured note whose coupon rate is linked to a reference rate has a coupon reset formula that differs from the previous example. Typically, the coupon formula on floaters is such that the coupon rate increases when the reference rate increases, and decreases when the reference rate decreases. There are structured notes whose coupon rate moves in the opposite direction from the change in the reference rate. Such issues are called inverse floaters or reverse floaters.
The coupon reset formula for an inverse floater is:
Coupon rate = K – [L × (reference rate)]
When L is greater than 1, the security is referred to as a leveraged inverse floater.
suppose that for a particular inverse floater K is 12% and L is 1. Then the coupon reset formula would be:
Coupon rate = 12% – (reference rate)
Suppose the reference rate is the 1-month LIBOR; then the coupon formula would be:
Coupon rate = 12% – (1-month LIBOR)
Note: The “London Interbank Offered Rate (LIBOR)” is a widely used reference rate for many financial instruments.
If in some month the 1-month LIBOR at the coupon reset date is 5%, the coupon rate for the period is 7%. If in the next month the 1-month LIBOR declines to 4.5%, the coupon rate increases to 7.5%.
Notice that if the 1-month LIBOR exceeds 12%, then the coupon reset formula produces a negative coupon rate. To prevent this, there is a floor imposed on the coupon rate. Typically, the floor is zero. There is also a cap on the inverse floater. This occurs if the 1-month LIBOR is zero. In that unlikely event, the maximum coupon rate is 12% for our hypothetical inverse floater. In general, it will be the value of K in the coupon reset formula for an inverse floater.
An inverse floater can be created when an investment banking firm underwrites a fixed-rate bond and simultaneously enters into an interest rate swap with the issuer where the maturity of the swap is generally less than the maturity of the structured note that will be issued. The investor owns an inverse floater for the swap’s tenor (that is, the term of the swap agreement), which then converts to a fixed-rate bond (the underlying collateral) when the swap contract expires. An inverse floater created using a swap is called an “indexed inverse floater”.
To see how this can be accomplished, assume the following.
The CFO wants to issue $200 million on a fixed-rate basis for 20 years. An investment banker suggests two simultaneous transactions:
Transaction#1: issue a $200 million, 20-year bond in which the coupon rate is determined by the following rules for a specific reference rate:
For years 1 through 5: Coupon rate = 14% – reference rate
For years 6 through 10: Coupon rate = 5%
Transaction#2: enter into a 5-year interest rate swap with the investment bank with a notional principal amount of $200 million in which semiannual payments are exchanged as follows using the same reference rate:
Issuer pays the reference rate
Issuer receives 6%
Note that for the first five years, the investor owns an inverse floater because as the reference rate increases (decreases) the coupon rate decreases (increases). However, even though the security issued pays an inverse floating rate, the combination of the two transactions results in fixed-rate financing for the issuer:
Rate issuer receives
From the investment bank for its swap payment: 6%
Rate issuer pays
To security holders as interest: 14% – reference rate
To the investment bank for its swap obligation: reference rate
(14% – reference rate) + reference rate – 6% = 8%
Type#2. Equity-Linked Structured Notes [Beyond Traditional Securities]
An equity swap can be used to design a bond issue with a coupon rate tied to the performance of an equity index. Such a bond issue is referred to as an equity-linked structured note. Such notes may be designed many different ways, but the basic idea is to blend the features of a low or zero-coupon bond with potential for the investor to participate in the upward movement of an equity index.
How is this done? – See below case example
Suppose the Universal Information Technology Company (UIT) seeks to raise $100 million for the next five years on a fixed-rate basis. UIT’s investment banker indicates that if bonds with a maturity of five years were issued, the interest rate on the issue would have to be 8.4%.
At the same time, there are institutional investors who are seeking to purchase bonds but are interested in making a play on (i.e., betting on) the future performance of the stock market. These investors are willing to purchase a bond whose annual interest rate is based on the actual performance of the S&P 500 stock market index.
The banker recommends to UIT’s CFO that it consider issuing a 5-year bond whose annual interest rate is based on the actual performance of the S&P 500. The risk with issuing such a bond is that UIT’s annual interest cost is uncertain since it depends on the performance of the S&P 500. However, suppose that the following two transactions are arranged:
On January 1, UIT agrees to issue, using the banker as the underwriter, a $100 million 5-year bond whose annual interest rate is the actual performance of the S&P 500 that year minus 300 basis points. The minimum interest rate, however, is set at zero. The annual interest payments are made on December 31.
UIT enters into a 5-year, $100 million notional amount equity swap with the banker in which each year for the next five years UIT agrees to pay 7.9% to the banker, and the banker agrees to pay the actual performance of the S&P 500 that year minus 300 basis points. The terms of the swap call for the payments to be made on December 31 of each year.
Thus, the swap payments coincide with the payments that must be made on the bond issue. Also as part of the swap agreement, if the S&P 500 minus 300 basis points (BP) results in a negative value, the banker pays nothing to UIT [Note: The trading desk of the investment banking firm can hedge this risk with a basis swap that pays a fixed or floating cash low in return for receiving the return on the S&P].
The next diagrams the payment lows for this swap. Consider what has been accomplished with these two transactions from the perspective of UIT. Specifically, focus on the payments that must be made by UIT on the bond issue and the swap and the payments that it will receive from the swap.
These are summarized as follows:
Interest payments on bond issue: S&P 500 return – 300 BP
Swap payment from the banker: S&P 500 return – 300 BP
Swap payment to the banker: 7.9%
Net interest cost: 7.9%
Thus, the net interest cost is a fixed rate despite the bond issue paying an interest rate tied to the S&P 500. This was accomplished with the equity swap. There are several questions that should be addressed:
- First, what was the advantage to UIT to entering into this transaction? Recall that if UIT issued a bond, the banker estimated that UIT would have to pay 8.4% annually. Thus, UIT has saved 50 basis points (8.4% minus 7.9%) per year.
- Second, why would investors purchase this bond issue? In real-world markets, there are restrictions imposed on institutional investors as to the types of investment or by other portfolio guidelines. For example, an institutional investor may be prohibited by a client or by other portfolio guidelines from purchasing common stock. However, it may be permitted to purchase a bond of an issuer such as UIT despite the fact that the interest rate is tied to the performance of common stocks.
- Third, is the banker exposed to the risk of the performance of the S&P 500? In the swap market, there are ways for the banker to protect itself.