5.3 PRODUCT MECHANICS AND APPLICATIONS
5.3.2 Interest-rate-linked notes
Structured notes with embedded interest rate options are common, appearing frequently when interest rates are low, the yield curve is steep, and interest rate volatility is on the rise; each one of these factors allows investors and issuers to benefit. Key structures in this category include inverse floaters, leveraged floaters, capped and collared floaters, range floaters, step-up bonds, and bonds with debt warrants.
Inverse floaters are structured to give investors a leveraged return to market interest rates, and tend to appear when investors have a view of future rates that diverges from the market implied view. As the name suggests, inverse floaters feature coupons that move opposite the market, i.e. as LIBOR rises, the coupon on a floater declines, and vice versa. For instance, if LIBOR is currently set at 4 %, the structured coupon on the FRN might pay a coupon of 8 %−LIBOR. As LIBOR rises (e.g. to 5 %), a standard FRN investor receives a greater return (5 %), but the inverse floating investor receives a lower coupon (3 %). Riskier versions of the note can also be created; these instruments, known as leveraged inverse floaters,11can feature risk/return payoffs with many multiples of leverage.12
The decomposition of the inverse or leveraged inverse structure suggests the investor holds a package comprised of a standard FRN and a swap, where it receives fixed rates and pays LIBOR onntimes notional, wherenis the leverage multiple (andn=1 for an unleveraged structure). Thus, if the fixed rate is set at 5 % and the leverage factor is 2, the investor receives (2 * 5 %, or 10 %) and pays (2 * LIBOR); it also receives LIBOR on the standard FRN, suggesting a combined total coupon of 10 %−LIBOR. The combined structure, floated via an SPE, is depicted in Figure 5.2.
Financial institutions and corporations seeking to lock in funding levels routinely issue capped and collared FRNs. The capped FRN is a package comprised of an FRN and a series of long issuer caps that establish a maximum borrowing cost. If forward rates are high (e.g.
the curve is steep) or short-term rates are especially volatile, the caps are expensive, meaning a higher return for investors; high forward rates increase the “lock-in” value for each reset date,
11Note that a variation on the leveraged floater theme appeared in the late 1990s – the deleveraged floater, with coupon payments set as a fraction of the actual floating-rate index.
12Other variations are also available. For instance, a fixed inverse floater pays a fixed rate for the first one to two years, and then converts into a standard inverse floater; this allows an investor to defer its view on rate movements until a future time period.
Figure 5.2 Inverse floater withntimes leverage
and the high volatility increases the time value for each date. In some instances, the strip of caps sold by investors via the note may be misvalued; this is particularly true when the curve is very steep. In such cases, the issuer can sell an equivalent strip of caps at higher levels in the market, using the crystallized differential to lower its funding costs. Another version of this structure, the collared FRN, incorporates a strip of short issuer floors to give investors a minimum market return while defraying some (or all) of the issuer’s cap premium cost. When the curve is steep, forward rates are significantly higher than current rates; this means that the floors the issuer has sold investors may be in-the-money in a current period, but may move out-of-the-money in a future period; the reverse scenario occurs for the caps. If the issuer can sell the floors to investors at a relatively high level, and repurchase an identical strip at a lower cost in the market, it again lowers its funding costs. Cost savings can run to more than 50 bps (though this depends on market circumstances). In certain other situations, the reverse transaction can also be arranged (e.g. the issuer sells caps and buys floors).13Figure 5.3 illustrates the collared FRN.
Note that several other variations seek to capitalize on the same arbitrage opportunities.
Collared FRNs with multiple cap/floor strikes can be arranged, with each caplet/floorlet fea- turing a unique strike. Ratchet-collared FRNs are similar in concept, but contain caplet/floorlet strikes that increase at particular intervals; such structures are most valuable to issuers when the implied forward rates suggest greater moneyness will accrue to the caplets. Capped and collared FRNs with participating caps/floors are also available. These, for example, may allow for increased participation levels as the cap strikes rise for each sequential coupon period, with a payoff equal to (cap strike−participation rate * (strike rate−LIBOR)). Obviously, not all collared or capped structures reference LIBOR; other rates, including constant maturity Treasury (CMT), EURIBOR, bank bills, and so forth, can also be used.
13A breakeven analysis is required to determine the economic viability of a capped or collared FRN, and to examine where the value lies. Let us consider the following example: a benchmark two-year FRN is quoted at L+50 bps, while a two-year capped FRN (6 % cap strike) is quoted at L+80 bps. If LIBOR is trading at 4.5 %, then we can define the maximum the rate can increase in one year before the capped FRN and the uncapped FRN break even; this analysis involves reinvestment of the first 12-month coupon at the future one-year uncapped rate. Solving the inequalities yields a LIBOR breakeven level of 6.64 %. Thus, if LIBOR exceeds 6.64 % in one year, the cap feature reduces the FRN’s yield by more than enough to cover the 30 bps cost of the cap. A similar analysis can be performed for collared FRNs.
Cap Cap premium
Investor
P&I
$
FRN issuer
Floor premium Floor Figure 5.3 The collared FRN
The range floater structure (also known as an accrual note) is similar in structure to the collared FRN, except that the caps and floors are replaced by digital options that provide a payout/coverage of either a fixed amount or zero. The range floater pays interest to note investors only on days when LIBOR (or some other floating-rate index) falls within the boundaries established by the upper and lower strikes of the digital options; for every day within a quarterly or semi-annual period that LIBOR falls outside the range, interest ceases to accrue. If LIBOR falls outside the bands for an entire quarter, investors lose interest for the full quarter. In exchange for potential risk of loss on the coupon, investors receive an enhanced coupon while the benchmark rate remains within the band. This suggests, of course, that investors are selling the issuer a strip of digital options, with the enhanced coupon representing premium. Use of the digital options means that the coupon/protection profiles are discrete rather than continuous, and the value of the note can change rapidly as the underlying rate/price approaches the upper or lower strikes. Ranges can be held constant over the life of the note, or they may be increased at specific intervals (coinciding with a positive yield curve and higher implied forward rates).
Let us examine an example of this structure. Assume that an investor buys a three-year range floater paying an enhanced coupon of three-month LIBOR+40 bps in a market when LIBOR is equal to 5 %. The note features a step-up range, where year 1 has a range of 5–6 %, and years 2 and 3 have a range of 6–7 %. We can determine the number of days the range floater can trade outside the range and still be equal to a standard FRN (i.e. the breakeven LIBOR level at which the range floater is equivalent to a standard FRN trading at LIBOR flat). In this example, the extra revenue earned over a full year amounts to 40.5 bps; the cost of trading outside of the range for one day is equal to approximately 1.4 bps, meaning that the breakeven position is 29 days. This analysis suggests that if LIBOR trades inside the range for more than 29 days, the investor’s position is profitable. Note that a more extreme version of the range floater, the knock-out floater, is comprised of a series of knock-out (barrier) options, rather than digital options, suggesting that if the reference rate trades outside of the range for even a single day, the coupon for the entire period is sacrificed (e.g. it knocks-out as the barrier level is reached); these are particularly risky versions of the accrual structure.
It is important to note that investors in capped/collared FRNs and range floaters face different risks. Investors in capped/collared notes are speculating that the rates implied by the yield curve are too high; if correct, they preserve the enhanced coupon representing the premium. Investors in range floaters, in contrast, are taking a view primarily on interest rate volatility (yield curve
moves are only secondary); specifically, they must believe that the premium received via the en- hanced coupon will be sufficient to make up for a potential loss in daily yield driven by volatility.
The step-up note is also quite common. Under this structure, which first appeared in the market in the late 1980s, the investor receives an above-market rate during the note’s noncall period (generally one or two quarterly periods), and then receives increasingly higher rates (step-ups) for each period in which the note is not called by the issuer; the step-up rates are likely to be below-market rates for the first few periods. The investor in this instance has sold the issuer a strip of call options, with the initial above-market rate constituting the premium.
A further interest-rate-linked bond meriting mention is the bond with attached debt warrant, giving the investors the option to purchase an incremental amount of new fixed-rate bonds (with terms specified at original issuance). In exchange for the option, the issuer receives a premium payment (generally in the form of a below-market coupon) that lowers funding costs. Since the warrants are attached to the host bond, the issuer also benefits from lower fees for any subsequent issuance. In addition, market convention calls for setting the new issue coupon at 25–50 bps lower than the host bond, creating a built in “cost saving.” Though the issuer can clearly benefit via lower costs, it faces a complication in being unable to estimate, in advance, the precise amount of bond warrants that will be exercised into new debt; much depends ultimately on the level of interest rates and credit spreads. In the extreme, the warrant may expire worthless, requiring the issuer to finance or refinance through alternate sources.
In addition to securities linked to interest rate references, government and private issuers launch notes and bonds that reference inflation levels. Such bonds allow investors to earn real rates of return based on inflation recorded over a particular period of time. In the US, such inflation-linked bonds are tied to the consumer price index (CPI), in the UK, to the retail price index (RPI), and in the Euro-zone, to the harmonized index of consumer prices (HICP).