new debt innovations

8/2/2019 New Debt Innovations

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Recent Debt Market

InnovationsPresented

by:Rajneet Kaur

Dilpreet Singh

Harleen KaurSakshi Thakur

M.Com (e.com)


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Introduction

The process of financial innovation involves creating newinstruments and technique by unpackaging and rebinding

the same characteristics in different fashion to suit the

constantly changing needs of the issuers and the

investors . Financial innovation has therefore been a continuous and

integral part of corporate world.

Here we will take a brief look at some of the recent

innovation that have done a lot to alter the financiallandscape.

All of these innovations are the work of financial

engineers but many would not have been possible

without an accommodative regulatory environment.


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Collateralized mortgage obligations

Zero coupon securities

Repurchase agreements

Junk bonds

Economic and legal defeasance

Shelf registration

Floating rate preferred stock and

Reverse floating rate debt

Recent Innovations in debt

market:


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Mortgage-Backed Securities (MBS)

Mortgage-backed securities (MBS) are

securities that represent an interest in a pool

of mortgage loans.

It is like a bond. Instead of

paying investors fixed coupons

and principal, it pays out thecash flows from the pool of

mortgages.


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Scheduled Cash Flows for a 30-Year

Fixed-Rate Mortgage

A 30-year fixed-rate residential mortgage makes a fixed payment each

month until its maturity. Each payment represents a partial repayment of

principal and interest. Over time, as more of the principal is paid off,

interest payments reflect a decreasing portion of each cash flow.


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The scheduled payments on a mortgage are fixed

from one month to the next, the cash flows to the

holder of a mortgage pass-through are not fixed. This

is because mortgage holders havethe option of prepaying their mortgages. When a

mortgage holder exercises that option, the principal

prepayment is passed to investors in the pass-

through. This accelerates the cash-flows to the

investors, who receives the principal payments early

but never receive the future interest payments that

would have been made on that principal. A possible pattern of payments, taking into account

principal pre-payments, of a mortgage pass-through

is illustrated as:


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How It Works/Example:

Let's assume that Ravi wants to buy a house, so he getsa mortgage from XYZ Bank. XYZ Bank transfers money into his

account, and he agree to repay the money according to a set

schedule. XYZ Bank may then choose to hold the mortgage in

its portfolio (i.e., simply collect the interest

and principal payments over the next several years) or sell it.

If XYZ Bank sells the mortgage, it gets cash to make other

loans. So let's assume that XYZ Bank sells Ravis mortgage to

ABC Company, which could be a governmental, quasi-

governmental, or private entity. ABC Company groups Ravismortgage with similar mortgages it has already purchased

(referred to as pooling the mortgages). The mortgages in the

pool have common characteristics (i.e., similar interest rates,

maturities, etc.)


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ABC Company then sells securities that represent aninterest in the pool of mortgages, of which Ravis mortgageis a small part (called securitizing the pool). It sells theseMBS to investors in the open market. With the funds fromthe sale of the MBS, ABC Company can purchase moremortgages and create more MBS.

When Ravi makes his monthly mortgage payment to XYZBank, they keep a fee or spread and send the rest of thepayment to ABC Company. ABC Company in turn takes a feeand passes what's left of Ravis principal and interestpayment along to the investors who hold the MBS.


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All the investors in the same pass-through

instrument hold identical securities with identical

cash flows, identical maturities and identical

rights. This single structure does not suit theneeds of all potential mortgage investors.

Financial engineers set to work on the problem

and eventually created a multiclass mortgage-backed instrument called a collateralized

mortgage obligation


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Collateralized Mortgage Obligation

(CMO)

A collateralized mortgage obligation (CMO) is

a fixed income security that uses mortgage-backed

securities as collateral. Like other structured

securities, CMOs are subdivided into graduated riskclasses, called tranches that vary in degree based

on the maturity structure of the mortgages.

Salomon Brothers and First Boston created the

CMO concept. A CMO is essentially a way to create

many different kinds of bonds from the same

mortgage loan so as to please many different kinds

of investors


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How It Works/Example:

When an investor purchases a CMO, he or she

purchases some class or tranche of the

security whose risk depends on the maturity

structure of the mortgages backing it. These

tranches are usually designated as A, B, C.

In the basic or plain vanilla CMO, each tranche

is entitled to receive a pro-rata share ofinterest, just as with a pass-through, but only

one tranche at a time receives principal.


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Example: At the beginning, only the firsttranche receives principal. This tranche, calledthe fastest pay tranche, receives all principal

collected by the servicer, whether paid ontime or prepaid, until all of the tranchesprincipal has been amortized. The tranche isthen retired and the second tranche becomes

the fastest pay tranche. The number oftranches on any one CMO may be as few asfour as many as ten or more.


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The segregation of cash flows into three sequential pay

tranches is illustrated. All three participate in interestpayments, but principal payments flow exclusively to the A

bonds until they are retired. After that, all principal payments

flow to the B bonds until they are retired. Finally, all principal

payments flow to the C bonds until they are retired.


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The structure of the tranche guarantees thatthe first tranche will have a very short life, thesecond tranche will have somewhat longer

life, that the third tranche will have still longerlife and so on. Thus, a long term instrument-the mortgage or pass-through is used tocreate a series of distinct instruments, thetranches that have short, intermediate andlong lives. The investor can pick the tranchethat most closely mirrors his or her needs.

Because the investor can purchase needspecific securities and, hence, have less riskthan that associated with whole mortgages orpass-through, they are willing to pay little

more for these instruments.


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Asset-Backed Securities (ABS)

An asset-backed security (ABS) is a

security backed by the cash flows of a

pool of assets. Home equity loans, autoloans, credit card receivables, and

student loans commonly back this class

of securities. However, nearly any cash-producing situation can be securitized.


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While any payment stream can be used to

back a debt issue the most frequently used

are automobile receivables.

The structure of ABS is similar to MBS. They

may be single class instruments like mortgage

pass through or multi class instruments like

CMOs.


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Any questions?


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Zero coupon bonds may be long or short term

investments.

Strip bonds:- Investment banks or dealers may

separate coupons from the principal of coupon

bonds, which is known as the residue, so that

different investors may receive the principal andeach of the coupon payments. This creates a supply

of new zero coupon bonds. This method of creating

zero coupon bonds is known as stripping and the

contracts are known as strip bonds. Dealers normally purchase a block of high-quality

and non-callable bondsoften government

issuesto create strip bonds.


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Difference between a zero-coupon bond and a

regular bond

The difference between a zero-coupon bond

and a regular bond is that a zero-coupon bond

does not pay coupons, or interest payments,

to the bondholder while a typical bond doesmake these interest payments.


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Zero Coupon bonds- History

The first zero coupon products involving Treasury securities and

having a maturity greater than one year were introduced in 1982 by

Merrill Lynch known as Treasury Investment Growth Receipts or

TIGRs.

To give competition to TIGRs CATS, LIONs, COUGARs, DOGs andEAGLEs were products of other investment banks similar to TIGRs

which were introduced.

For investment banks, the incentive for creating zero coupon

products was two fold. First, the investment bank purchased a

bond, stripped it to create a series of zeros and then sold these

zeros to public.

The investor benefits afforded by zeros were reflected in their price

so that series of zeros that could be created from a conventional

bond had a collective value that exceeded that of the bond.


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Zero Coupon bonds

The purchaser of zero coupon Treasuries who matches thebonds maturity and horizon is freed from interest rate risk,default risk and reinvestment risk.

Zero coupon bonds are exposed to purchasing power risk-

that expected because of unforeseen changes in the rate ofinflation but these are eliminated by coupon inflation indexedbonds also.

The demand for zeros created a demand for the bonds thatare raw material for making zeros.

Seeing popularity of Zero Coupon bonds, US treasurycreated its own program called Separate Trading ofRegistered Interest and Principal of Securities (STRIPS) thatallows stripping of all non callable coupon issues with originalmaturities of 10 or more years.


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Types of Zero Coupon Bonds

Treasury zerosbacked by the U.S.

government

Municipal bondsissued and backedby municipalities

corporate zerosissued by

corporations

the fourth type iscalled short term

zero coupon bond.

Types


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Advantages

Pension funds and insurance companies like to own long

maturity zero-coupon bonds because of the bonds' high

duration. They are also more advantageous when placed in

retirement accounts where they remain tax-sheltered.

buy zero coupon bonds at a deep discount.

As the bond matures, the interest is accrued and the bond

increases in value.

investors predictability for the long-term.

They allow corporations, municipalities, and the government

to continue using the loan amount without having to pay back

interest.

Diversified portfolio.


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Disadvantages

Interest rates changes can swing price of the

bond in either direction. This means that if

you want to sell it before maturity, profit is not

guaranteed.

Another major drawbacks is that you still have

to pay income taxes capital gains tax.

One final drawback to investing in zeroes is

that they are callable.


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Price of a zero-coupon bond

P = M / (1+r)n

where:

P = price

M = maturity value

r = investor's required annual yield / 2n = number of years until maturity x 2

For example, if you want to purchase a Company XYZ zero-coupon

bond that has a $1,000 face value and matures in three years, and

you would like to earn 10% per year on the investment, using the

formula above you might be willing to pay:

$1,000 / (1+.05)6 = $746.22

When the bond matures, you would get $1,000. You would

receive "interest" via the gradual appreciation of the security.


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The greater the length until a zero-coupon bond's maturity,

the less the investor generally pays for it. So if the $1,000

Company XYZ bond matured in 20 years instead of 3, youmight only pay:

$1,000 / (1+.05)40 = $142.05

This chart shows the growth in value of a $10 000 zero coupon bond


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This chart shows the growth in value of a $10,000 zero-coupon bond,

purchased on January 1, 2011, and maturing on December 31, 2030. The

illustration assumes an original-issue yield of 4.20% and ignores the potential

fluctuation of interest rates during the 20-year period. The purchase price of

such a bond would be $4,323.


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Tax

For tax purposes, holder of a zero-coupon bond owes

income tax on the ir that has accrued each year, even

though the bondholder does not actually receive the

cash until maturity. In India, the tax on income from deep discount

bonds can arise in two ways: interest or capital gains.

It is also law that interest has to be shown on accrual

basis for deep discount bonds issued after February2002. This is as per CBDT circular No 2 of 2002 dated

15 February 2002.


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Zero & Conversion Arbitrage

In conversion arbitrage, an instrument (or group of instruments)with a given set of investment characteristics is converted into aninstrument (or a group of instruments) that has a different set ofcharacteristics.

The creation of zero coupon bonds from conventional bonds is a

classic example of conversion arbitrage.

combine or

decompose

input cash

flowsSecurity n

Security 2

Input securities

Security 1

Security n

Security 2

Output securities

Security 1


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The Zero Coupon Yield Curve

An interesting feature of zeros- which is unique to zeros- is that their

maturity and duration (Macaulay Duration) are identical.

A yield curve drawn on yields of zero coupon bonds against their

maturities is known as zero coupon yield curve or simply spot yield.


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Zeros in Financial Engineering

A zero coupon bond entitles its holder to a single

payment at a pre specified point in time. Both the

initial purchase price and cash flow at maturity are

known at the time of purchase. By stringing together

an appropriate assortment of zeros, a financial

engineer can replicate the cash flow pattern of any

form of debt.

The process by which zeros are created can be reversedand the conventional treasury bonds can be recreated.

Such a strategy would be profitable if conventional

bonds of some maturity are priced above the cost of

creating one via the assembly of zeros.


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Zeros in Financial Engineering

Cash flows

1 timeCash flows

2 time

Cash flows

n time

Cash flows

1 2 3 n

time

Cash flows pattern associated with a

mortgage

A ti ?


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Any questions?


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DEFEASANCE

In the context of an issuers debt obligations,

defeasance involves the acquisition of a

riskless portfolio of bonds such that the cash

flow on the bonds are at

least sufficient to pay

the interest and the

principal on the debt

defeased.


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Types

Economicdefeasance

Legaldefeasance


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Economic defeasance is the process of

removing the debt from a balance sheetby depositing Treasury securities into anirrevocable trust.

An irrevocable trust is a trust thatcannot be altered or terminated by itscreator without the consent of the

beneficiaries. Legal defeasance renders the debt

indenture null and void.


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Example: A corporation sells a 30 year mortgage

bond having a face value of Rs.50 million andpaying a semi annual coupon rate of 6.75%. The

firm uses the proceeds to fund a new plant.

Suppose that ten years later, after interest rates

have risen, the bond is priced to yield 10.25% and

its aggregate value is Rs.35.24 million. The firm is

cash heavy & would like to eliminate its debt.

If the firm buys backs the bond then it will resultin a taxable event- which firm would like to avoid.

The solution is an economic defeasance.


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As it happens, non callable Treasury bonds ofsimilar maturity (20 years) and coincidentally,carrying an identical semi-coupon of 6.75% are

priced to yield 10%. The firm could purchase Rs.50 million (face

value) of these T-bonds at a cost of Rs.36.06million. The T-bonds are then placed in anirrevocable trust with the interest and principalon T-bills used to meet the obligations on thefirms bond issue.

The firms Rs.50 million bond liability is nowdefeased at a cost of Rs.36.06 and the firm can

remove Rs.50 million liability represented bybond from its balance sheet. The gain (Rs.50 million-Rs.36.06 million) is

amortized over the remaining 20 years.


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Defeasance can be employed to remove

liabilities stemming from almost any type ofdebt (except floating rate debt and

convertible debt).The firm has low coupon

debt on its books

Needs to reduce its useof leverage

Anticipates decline in

interest rate

Cash heavy

It

isused

when


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Economic defeasance should not concern the

holders of the firms debt because it does

not trigger a tax event, there are no changes

in the cash flows to the bondholders and the

issuer is still bound by the bond indenture.

Legal defeasance has the additional benefit

from the issuer of removing all restrictive

covenants of the defeased debt.


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Example, under economic defeasance the firmcould not dispose its assets backing its bond.

Such disposition is specifically prohibited by thebond indenture. Once the bond has been legallydefeased, however, the assets can be disposedof in any manner management sees fit.

The downside of legal defeasance is that legaldefeasance results in a taxable event for thedebt defeaser.

For the holders of debt, however, legaldefeasance is attractive because legallydefeased debt receives a top investment graderating.


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The extinguishment of debt. While defeasancetechnically refers to extinguishment by any

method (for example, by payment to thecreditor), in practice it is generally used to meandischarging debt by presenting a portfolio ofsecurities (usually, Treasury obligations) to atrustee who will use the cash flow to service theold debt.

This procedure permits the firm to wipe the debt

off its financial statements and to show extraincome equal to the difference between the olddebt and the smaller, new debt.


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THE REPO/REVERSE MARKET

A repo or more precisely, a repurchaseagreement is the simultaneous sale andrepurchase of security for different settlementdates.

A reverse or, more precisely, a reverserepurchase agreement, is the mirror image of arepo i.e. a reverse repo is the simultaneouspurchase and sale of a security for differentsettlement dates.

Repos and reverse are nothing but short term

loans collateralized by the underlying security. They are used to:1. Obtain short term funding.2. To invest short term cash balance3. To obtain securities for use in short sales.


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Perspective of the Borrower

The borrower sells the securities with thepromise to repurchase them at a later date at aspecific price.

The borrower assumes all interest rate risk

associated with the securities. The difference between the SP and the

Repurchase price represents the interest on theloan.

Thus, a securities dealer holding temporarilyunneeded securities can sell them to an investorunder a repurchase agreement.


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Example: The seller dealer sell $20 mn(FV) 6-month bills to an investor for $19,199,200

with a promise to repurchase the bills 3 dayslater at a price of $19,212,400.

The difference between the SP and the

Repurchase price represents,$13,200,represents interest paid by the selling dealerto the investor for a 3-day loan.

Motivation of the selling dealer is the short-

term loan it receives at a very low interestrate.


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Perspective of the Lender

The lender buys the securities with thepromise to sell them back. The lender mightbe another dealer in need of securities or a

corporate treasurer with excess cash to invest. The lender has a very secure investment.

Firstly, the loan is fully collateralized.

Secondly, the borrower has assumed allinterest rate associated with a change in themarket value of the collateral.


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A large volume of repos are done on anovernight basis called overnight repos. Rates on

overnight repos are usually lower than the callrate. It is better than no return for the investorswho lack access to the call market.

By rolling over overnight repos, the investor can

effectively manage surplus funds when theavailable quantity of surplus funds is uncertainfrom day to day.

Repos for longer term say 30 days are known as

term repo. Reverse market is a very effective way to

acquire securities for short sales.


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JUNK BONDS

Junk Bonds, also known as high yield and speculative gradebonds are bonds having less-than-investment grade rating.

For decades these bonds are difficult, if not impossible to

issue.

They were earlier used as investment grade and subsequentlydeteriorated to speculative grade (with subsequent rise in

yields). Such issues were often termed as fallen angels.

Sellers of junk bonds had difficulty in entering high yield

markets Many money managers managing fixed income portfolios are

barred from investing in any security having a less-than

investment grade rating.


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The inherent default risk of holding junk bonds can bedramatically reduced by diversification. The inability ofissuers to issue such securities limited the ability of

investors to diversify junk portfolios. The nature of the junk bond market began to change in mid

1970s, when the investment banking firm (Drexel)demonstrated, by way of detailed studies, that the yieldsrequired on speculative grade securities were excessive

relative to their actual default risk. This theory purported that long term investors in diversified

junk portfolios would have fared consistently better in year-to-year returns even with some defaults than investors in

investment grade debt. Given this evidence, Drexel concluded that new issues of

highyield securities should be saleable and undertook todevelop this market.


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In the beginning , the

buyers of the high debtwere the individuals andfew high-yield MutualFunds.

But they were later joinedby other holders of fixedincome portfolios includinginsurance companies,

pension funds, banks andsaving and loanassociations.

Any questions?


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Any questions?


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Shelf Registration

In March of 1982, in an effort to reduce the cost and

the time associated with bringing a longer-term issue

to market, the SEC approved rule 415, popularly

known as Shelf Registration. The issuance of securities

has been enhanced by

the introduction of Shelf

Registration.


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Shelf Registration allows a firm to file aregistration statement with the SEC and then totap that filing as windows of opportunity appearor as the need arises. The filing is good for two

years and has reduced flotation costs for thefirms that use it.

Shelf Registration is a registration of a new issuewhich can be prepared up to three years in

advance, so that the issue can be offered quicklyas soon as funds are needed or market conditionsare favorable.


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For example, current market conditions in thehousing market are not favorable for a specific firmto issue a public offering. In this case, it may not be agood time for a firm in the sector (e.g. a home

builder) to come out with its second offering becausemany investors will be pessimistic about companiesworking in that sector.

By using Shelf Registration, the firm can fulfill all

registration-related procedures beforehand and go tomarket quickly when conditions become morefavorable.


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Floating Rate Preferred Stock

Floating Rate Preferred Stock is any

preferred stock on which the dividend rate is

periodically reset or adjusted according to

well defined rule. Some of the variants are Adjustable Rate

Preferred Stock (ARPS) and Single Point

Adjustable Rate Preferred Stock (SPARS)


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ARPS

In ARPS, the rate is periodically reset (usuallyquarterly) to a fixed spread over the highestpoint on the Treasury Yield Curve.

For example, the spread might be 50 basispoints over the yield curve. Thus, if on thereset date, the highest yielding Treasurysecurity is yielding 8.72%, the preferred

stock dividend rate would be set at 9.22%and paid in the stocks par value.


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SPARS

SPARS resets

periodically like ARPS

but the dividend rate is

reset to a specificreference rate such as 3

mth T-bill or 3-mth

LIBOR.


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Reverse Floating Rate Debt

Reverse floating rate debt also called reversefloaters, work the same way as regular floatingrate debt in the sense that the rate is periodicallyreset based on the some reference rate.

But, in this case, the rate adjustment is in theopposite direction of the movement in thereference rate.

This requires that the coupon be stated in terms of

the difference between a constant and thereference rate.


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Conclusion

A great many of the financial engineering

innovations of the last decade and a half

have involved the manipulation oftraditional forms of fixed income

securities and the creation of new forms.

Many of these innovations represents

bold breaks with tradition.


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Some of the more important fixed income

innovation of the last fifteen decade were the

introduction of zero coupon bonds; multi-classmortgage-backed and assets-backed

securities; the development of the

repo/reverse market; the advent of the debtdefeasance; the emergence of a broad-based

junk bond market; simplified procedures for

the issuance of securities; and the creation of

variant forms of preferred stock and reverse

floating rate debt.


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new debt innovations

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