Derivative-linked securities
Key Concepts
Any of the derivative instruments described in previous sections can be combined with a bond or note to create a structured asset whose performance mimics that of the derivative itself.
Although the derivatives are sometimes said to have been 'embedded' (hence the alternative name 'embeddo' for these bonds) in the fixed-income instrument it is more accurate to say that the buyer of the structured asset has purchased a combination of derivatives in addition to a floating-rate, fixed-rate or zero coupon bond.
The result is an instrument whose coupon and/or principal payments create cashflows similar to those created by the purchase of naked derivative instruments.
These securities are sometimes divided into two classes.
First generation structured assets generally share the following characteristics.
They contain only one floating rate index; the maturity of the floating rate index coincides with the reset and payment frequency - e.g. three-month Libor coupons must be reset and paid quarterly; the floating-rate index is of the same country as the currency of denomination (no quantization); and no exotic options are embedded.
So in general, the index rate and discount rate of these notes are equal to each other and to the to-maturity Treasury rate.
Second generation structured assets incorporate design complexity in addition to embedded options.
These include notes containing index maturity to reset frequency mismatch (such as a CMT FRN where coupons are linked to 10-year Treasury rates but are reset and paid on a quarterly basis); notes that pay a coupon based on the differential or sum of a number of indices; notes that include embedded exotic options; notes incorporating quantization; notes where either the principal or coupons are linked to formulae and cross-category bonds whose performance is linked to the relative performance of two or more different asset classes.
Structured assets can be created to give tailored exposure to any asset class on which there are derivative instruments.
Principal {coupon} Indexed Note is a generic phrase for any structured note whose redemption {coupon} is linked to the performance of some asset or index.
The examples below are just a few of the combinations of fixed-income instrument, derivative instrument and asset class that can be tailored to meet investors' requirements.
CALLABLE FIXED FLOATER
An FRN that initially pays the investor an above market yield for a short non-call period and then, if not called, steps-up to a higher coupon rate. If the bond is not called, the stepped-up coupon is below prevailing market rates (if not the bond will have been called). The investor initially receives a higher yield as he has implicitly sold a receiver swaption.
More complex versions, multi step-up callable bonds, have coupons that step up over their lives and are callable on each step-up date. Investors have effectively sold the issuer a Bermudan call option on the note for which they receive the higher coupon. The bonds are usually swapped into floating rate Libor in which case the counterparty (paying the multi-step-up coupon in exchange for Libor less a spread) holds a Bermudan receiver swaption (to receive the multi-step-up coupon) which cancels the swap on exercise. The call on the note is triggered by the swap counterparty calling the swap. Also known sometimes as a step-up bond.
CAPPED (floored, collared) FLOATING RATE NOTE
A capped FRN is a note whose maximum coupon is capped but paid at a premium over Libor versus vanilla FRN coupons. Investors have bought an FRN and sold a strip of caps. The premium from these sold options is monetized in the form of the higher interest rate spread over Libor. Similarly, collared FRNs and floored FRNs are available.
The collared note has a minimum and maximum coupon and contains two embedded options. The issuer {investor} is effectively long {short} a cap and short {long} a floor. In a falling rate environment these notes outperform significantly since the cap is unlikely to be hit (so the investor stands to keep the premium) and the floor is gaining in value. Conversely, it underperforms significantly in a rising rate environment. This combination gives collared FRNs surprisingly high duration compared with vanilla or floored FRNs.
The floored note has a minimum coupon giving investors protection against lower short-term rates but, since they must pay for the floor, this is at the cost of a spread to Libor (or some other index) below that on equivalent FRNs. The risk for investors is that rising rates push the floors out-of-the-money, leaving them with a note that underperforms vanilla FRNs. They perform best in environments in which the yield curve is steeply positive but in which rates fall. This makes the floors cheap to buy at the outset and then means that they move handsomely into the money. More complex variants can be constructed.
CLIQUET NOTE/BOND
A note or bond where the coupon each year is determined by the performance of some reference asset or security in that year, subject to a minimum of zero.
The bondholder therefore holds a strip of options on which each of the strikes sets on a forward basis, most usually as a percentage of spot on a given future date, rather than being fixed today. To determine the coupon, the spot rate at the beginning of the coupon period would be compared with that prevailing at the end. The investor would receive the option payout (or not) in the form of interest, and the option strike for the subsequent period is fixed. Also known as forward starter/setting bond.
CORRIDOR [floating-rate] NOTE
Corridor options can be embedded in notes to create corridor FRNs (the investor is effectively long an FRN and short the digital options). In any note or FRN of this genre, the principal and/or coupons are linked to the number of or percentage of days during a specified period of time during which some reference asset (e.g. Libor, a spread such as 10-year CMT rates less Libor or an exchange rate) is above, below or in between a range.
There are two basic categories resurrecting and extinguishing (the latter is also called a [binary] corridor or accrual note). With resurrecting notes, trading outside the range does not prejudice the investor's ability to accrue further coupon if the reference asset subsequently trades back inside the range. With extinguishing notes, no further coupon may be earned.
A common example of the former would be a note that in a market interest rate environment of 5%, paid a coupon of 10% x (n/N) where n is the number of days spot USD/DEM trades between 1.70 and 1.90, and N is the total number of days that it could potentially have done so (n/N is therefore the percentage of days that it did.) With an extinguishing note, once the reference rate trades at or outside the range, the day count is frozen and cannot subsequently increase.
The basic corridor FRN can then be further altered by overlaying strategies seen in other structured assets. They can be principal guaranteed; instead of either accruing coupon or nothing, notes can have two fixed coupons, one high coupon payable if the underlying trades within the range and one low coupon payable if it does not (fixed accrual note); notes can be structured with a re-settable range (re-settable corridor note), for example so that investors start each period in the middle of the range; the range structure can be quit (quittable corridor note); investors themselves can specify the range; the note can be structured so that accrual only occurs if both the upper and lower range values are hit (limit range FRN) and so on. Investors in these notes are taking both a directional view as well as a volatility view. They also face unusual price behaviour. For example, if the underlying has traded through the lower boundary, the note will actually gain in value if spot or the forward rate then re-approaches the lower boundary, while the same rise just below the upper boundary will have the opposite effect. The note will begin to lose value even before the forward price crosses this upper limit as the digital option, which the investor is short, has a non-zero delta and so increases in value as it reaches the strike. Digital options also have larger vegas than other options which increases the volatility risk of accrual notes. In high rate environments in which the yield curve is steep, the notes rapidly approach the value and duration of a zero coupon instrument.
The popularity of these structures has led to a proliferation of names including memory note, accrual note, fairway note, range (floating-rate) note. Interest rate versions are sometimes known as Libor enhancement accrual notes or LEANS.
Example 1
A US dollar investor might want to improve upon the current one-year dollar deposit rate of 5.90% by taking a view on EUR/USD exchange rates. For the right to enhance the yield if his rate view is correct, he is willing to accept a lower minimum yield. So, part of the 5.90% depo rate is used to buy an FX corridor option with a corridor range of 1.0250 to 1.0650 and a pay-out ratio of 1 to 2.75 (that is, the maximum payout of the option is 2.75 times the premium invested. The option costs 4.00% of the amount invested, so if the spot rate traded outside the range for the entire year, the investor would receive no additional payment and would receive a yield of just 1.90% (5.90% - 4.00%). The return on the note is calculated as yield = 1.90%($) + (no. of days spot fixes in the range x fixed multiple of premium)/total business days in option period. In this case, the minimum payout is 1.90% and the maximum is 12.90%. The binary version, given the greater likelihood of a low payout is cheaper and has a higher maximum payout. A range binary option with the same boundaries as the FX corridor option above would cost less (2.00% of the amount invested) and its payout ratio would be much higher (1 to 10). This gives a minimum 3.90% return and a maximum 23.90%.
Example 2
A two-year Libor enhancement yield note might pay Libor + 100 bp with interest accruing only on days when three-month Libor is between 3% and 4% in the first six months, 3.125% to 4.75% in the next six months, 3.25% to 5.5% in the third six months and 3.5% to 6% in the last six months. Assuming 360-day convention, so that each semi-annual period has 122 days, the investor has sold the following package of binary or digital options for the first six month period 244 binary options on three-month Libor - 122 calls with a strike of 4% and 122 puts with a strike of 3%; for the next period, the same quantities of call and puts but with respective strikes of 4.75% and 3.125%, and so on. Every day, one call/put combination is either exercised or expires. If on any day three-month Libor is high enough for the calls to be exercised, then the purchaser of the range note - the seller of the binary option - effectively pays the holder of the binary call ((3-month Libor + 100 bp)/360) x principal amount of bond. Likewise, on any day, if three-month Libor is low enough that the binary put is exercised, then the purchaser of the note effectively pays the buyer of the put the same amount. Hence the spread to Libor payable by such notes - in this case 100 bp - is determined by the level of premium obtained for the options. This will be determined by the width of the range (the broader it is, the less likely the options are to be exercised and so the less premium they will command) and the volatility of Libor (the higher it is the higher the premium for the options.)
Credit-linked note (CLN)
A bond whose coupon payment and/or principal redemption is linked to the credit status of an underlying reference asset. In the simplest form, a CLN consists of a bond issued by a highly-rated borrower packaged with a credit default swap on a less creditworthy risk. Usually the issuers are banks that wish to sell exposure to a particular emerging country or a particular borrower by issuing a bond linked to that country's or borrower's default. If default occurs, the investor receives a educed payout (and in some cases nothing). Because the embedded credit default swap can create synthetic maturities of the underlying reference asset, and because it can be combined with currency-swaps to alter the currency of the credit-linked note's coupon and principal payments, the buyer of the note gains access to an investment that is either difficult to find or that does not exist in the cash market.
The structure of the CLN depends on the the underlying credit default swap. Usually the swap is cash-settled according to the recovery value of the relevant reference securities. So, if the reference asset defaults and its recovery value is 60%, then the CLN will pay accrued interest from the last payment date until (say) five days before the credit event notice day plus 60% of par (or instead of cash settlement may deliver the physical). The more aggressive versions of the CLN incorporate a digital credit swap which pays a predetermined fixed amount or pre-determined percentage of notional principal. This creates CLNs with fixed payouts in the event of default in the reference asset. The most aggressive variety, known as the zero/one CLN (because it is digital), pays out zero in the event of default. Many other coupon/principal combinations are possible such as example 1.
Example
An Italian investor wishes to increase exposure to Brazil but is not allowed to purchase Brady bonds. A bank issues a Euro-denominated note linked to the Republic of Brazil's $4,331,319,000 EI floating-rate notes due April 15 2006. If there is a credit event, the Euro notes pay a 5.95% per annum coupon accrued until the credit event with redemption at par. If there is no credit event before maturity then the interest paid is zero but redemption is at 156.9% of par. The Euro notes maturity matches that of the reference asset but is rated single-A against the reference asset's rating of B1/BB-.
Example
An investor is looking to add to his Czech Republic exposure and would like to purchase SPT Telecom's five-year 5.125% Euro note. However no paper is available. At the same time, a number of western banks are looking to buy default protection on the Czech Republic and default swap levels look attractive to cash. The investor must buy funded exposures and cannot enter directly into derivative contracts. A four-year 5.125% CLN linked to default on the Czech Republic, collateralized by World Bank Eurobonds can be structured that is 10bp cheap to SPT Telecom despite being one-year shorter and a better credit.
The basic structure is sometimes known as a two-name basket credit note, but CLNs can be constructed with more than one reference asset. Basket CLNs'. principal and/or coupon payments depend on there being sufficient non-defaulted assets in a portfolio of reference assets to pay them and so offer investors risk mitigation through diversification. First to default basket notes increase risk (and return) as it only takes a credit event in one of the reference securities/counterparties to trigger redemption of the CLNs. CLNs can also be structured in which the issuer has the right to substitute different securities for the reference assets effectively securitizing a switch asset swap.
Basket CLNs are usually issued by banks optimizing regulatory capital usage. They are complex in structure because to obtain ratings the underlying exposures have either to be individually identified, which is not optimal for those borrowers or counterparties, or they have to be aggregated and tailored in a way that suits both the buyer of credit protection and the ratings agency.
Example 3
A bank wishes to free up credit lines to European bank counterparties. It issues a note that pays six-month Libor plus a margin, where the margin is 0.875% minus 20bp for each merger between two reference entities subject to a minimum margin of 0.40%. Interest payments will stop if a credit event takes place. Redemption is 100% of the nominal amount unless there is a credit event, in which case notes are redeemed 15 business days after the credit event takes place. The redemption amount in principal x a reference price which is the best available bid, 10 business days after the credit event, for a predetermined amount of the reference securities that triggered the credit event. A credit event is triggered if any of five reference entities fails to make timely payments in respect of any of their obligations. The investor is taking the risk of default of any of the institutions in return for an attractive margin over Libor. This kind of note can also be structured with reference to specific securities.
Leveraged CLNs have also been popular. These are created simply by increasing the notional principal of the underlying default swap above the principal value of the CLN. Some of these notes (and all CLNs and repackagings can incorporate this feature) incorporate a trigger spread. If the reference assets fall below a certain price - usually at the point at which the investor will lose more than the initial investment - the whole trade is unwound and the investor receives the recovery value of the note.
Example
An investor believes that Russian debt will recover from current levels. He buys a two-year leveraged CLN callable after one year that, for an initial investment of $30 million gives him exposure to $60 million of Russian risk. Yields are high, but if the reference assets default, and the recovery rate is lower than 50%, the investor will lose more than the initial investment.
And credit-linked notes can be constructed that securitize sovereign risk guarantees rather than credit default swaps. These notes offer investors increased yield in return for taking on the risk that there will be a non-convertibility event in the currency in which the reference assets are denominated.
Example
A Portuguese investor believes that the market's perception of Brazilian risk is exaggerated. He buys a convertibility-linked note whose underlying assets are real-denominated assets of the Republic of Brazil. If the real remains freely convertible, the investor receives three-month Lisbor + 130bp and 100% of the notes' principal in escudos. If there is a convertibility event as defined in the term sheets, then the notes will redeem and the issuer will have the right to deliver any of the reference obligations in a face value equivalent to the notional amount multiplied by the last exchange rate, or the same amount of the now unconvertible reals. The investor also accepts the risk of tax and regulatory changes.
CURRENCY PROTECTED NOTE
A bond whose coupon and/or principal redemption is denominated in one currency and indexed to a reference index in another. For example a US dollar FRN paying an investor Euro Libor in dollars plus a fixed spread. Such structures are said to be quantized and are also known as differential notes and diff floaters because they incorporate differential swaps/options (not to be confused with notes such as the CMT-Libor differential note, so-called because they offer a play on the spread between two reference indices).
Quantization can be applied to almost any structured asset. So a quantized inverse floater might pay 9.11% minus six-month sterling Libor paid in US dollars to provide a currency risk averse US investor with a bullish interest rate play on sterling. A leveraged diff floater is just the combination of a leveraged FRN with a differential swap and might pay 2 x (three-month Euribor minus three-month dollar Libor) minus a spread.
DE-LEVERAGED FRNS
Floating-rate notes whose coupon is determined by formulae in which the reference index is multiplied by less than one. They underperform when the reference index rises and investors can be paid for taking this risk with high floors or high initial coupons. An example is the step up recovery FRN (SURF), a de-leveraged CMT FRN with a coupon floor that steps up over time. A five-year dollar Surf might pay 0.5 x (10-year CMT) + 1.50% subject to a coupon floor of 4.50%. The floor is higher than yields on benchmark Libor FRNs. The investor is short T-bonds and long an in-the-money T-bond call option.
DUAL CURRENCY NOTE/BOND
The combination of a fixed-rate bullet-repayment bond and a long-dated forward or option contract to create bonds with the principal denominated in one currency and interest payments in another. Either the investor or issuer could have the option to repay a fixed amount of either the first or second currency, based upon the interest payments, the principal, or both. If the investor has the option, the note will tend to have a below-market coupon and vice-versa.
An example is a USD note issued at par in either USD or EUR at the issuer's choice, and where the coupons are in fixed USD or EUR at the investor's choice. The exchange rate for converting USD amounts into EUR amounts is set at, say spot on the day the note is launched. There are a number of variants the tri-currency note/bond (also known as tri-colour note/bond) in which the principal or coupon can be paid in any one of three pre-specified currencies instead of only two e.g. a USD bond with issue and redemption at par and an annual coupon of 3% in JPY or 7% in USD or 8% in GBP at the issuer's choice; and the reverse dual currency bond - a dual currency bond in which the currencies that can be chosen for principal and interest are different e.g. a USD bond where coupons can be in USD or EUR and the principal can be in USD or JPY.
EXTENDIBLE FLOATER
An FRN, usually one-year, extendible to two or three years at the issuer's option. For example, if the two-year swap rate was trading at 5.65% and the forward curve was implying rates of 7.5%, an investor who wished to take a view against the pessimistic forward curve could buy a one-year extendible FRN under which he receives six-month Libor plus 50 bp for the first year. Then, if the two-year swap rate at the end of that first year is higher than 7.5%, the note will be extended a further two years and the investor's coupon would be fixed at 7.5%. Effectively the investor is selling a one-year option on the two-year swap rate at the forward rate (7.5%). If the investor had instead bought one-year paper paying Libor flat, the fixed reinvestment rate at the end of the year would have to be higher than 8% to outperform the extendible. See also index amortizing rate note.
INDEX AMORTIZING NOTE
A combination of a fixed-income instrument with a swap that mimics the performance of mortgage-backed products by amortizing according to a pre-set quarterly schedule that is linked to the level of a specific index, usually Libor or the PSA. As interest rates increase (or prepayment rates decrease) the slower the notes amortize, and so the longer their average life.
In this respect they behave like collateralized mortgage obligations (CMOs).
In some cases the amortization is all or nothing. So after the first year the notes will be called in their entirety if Libor has not risen by, say, more than 100 bp from the current level. The notes' coupon is fixed, and for the first year there can be no amortization. The coupon is set significantly higher than the prevailing yield on one-year notes. The notes are attractive if the yield curve is steeply positive and if the future sharp rate rises predicted by the curve do not occur. The note will then amortize more quickly than their initial pricing took into account (or they will be called after the lockout period) and the yield will be higher than on a vanilla FRN of the same life. The risk is that rates do rise quickly and the notes' average life extends, leaving the investor with a coupon fixed at levels that become more unattractive with every rate rise.
Interest-rate DIFFERENTIAL NOTES
An interest-rate differential note pays the investor the difference between two different interest rate indices. So, a CMT-Libor differential note pays the difference between the CMT rate and a short-term Libor index. A note might have a three-year maturity and pay 5.00% for the first year and thereafter pay the 10-year CMT rate less three-month Libor plus 1.60% reset quarterly with a minimum coupon of zero. This could give investors higher spot floating-rate yields than are possible with either the CMT FRN or vanilla FRNs. As with other CMT-linked notes, the main risk is that yield curve flattening will erode this advantage as the CMT-Libor spread decreases. The investor is effectively long a CMT FRN and long Eurodollar futures. Any indices can be used in place of CMT rates and Libor.
INVERSE/REVERSE PRINCIPAL {COUPON} INDEXED NOTE
Notes whose principal redemption {coupon payments} fall if a reference index/asset/spread rises and vice versa. The commonest example is the Inverse/reverse floating rate note, an FRN whose coupon rises (falls) as a floating reference rate falls (rises). A typical coupon is calculated as a fixed coupon minus the floating reference index e.g. 7.5% minus three-month Euribor. Such notes combine an FRN and an interest rate swap of twice the notional size. Libor resets in a rising rate environment will cause the bond to fall in value, not to reset its value to par and so investors usually also purchase a cap whose strike is set at the level of Libor that will produce a zero coupon that is, it is struck at the fixed rate element. If rates rise beyond this strike, producing negative coupons, then the long cap makes up the difference back to zero so coupons cannot become negative. The notes suit investors who want a high initial yield in an upwardly sloped yield curve and to benefit if rates fall.
There are many variants of the structure. The step-up inverse floater features a step-up constant (7.5% minus three-month Libor for the first six months, 8.5% minus three-month Libor for the second six months and so on) and also a fixed above-market first coupon followed by the inverse formula.
The principle of inverse performance can be applied to any asset class. For example, investors have used reverse principal exchange rate linked securities to take views on foreign exchange rates. These are currency-indexed notes whose principal repayment varies inversely with the value of a currency versus the repayment currency for example, a note repaid in dollars that varies in value according to the yen/dollar rate. Spread versions, known as dual index inverse floating-rate notes, are also available. These are FRNs whose coupon or principal redemption rises as the spread between (or the average of) two rates falls. For example, an investor might believe that Swiss and Euro short-rates are unsustainably high. If so, they could purchase a note that redeemed at par + 10 x (8.70% - Average CHF/EUR 3-year swap rate). This version is leveraged 10 times: every 1 bp change in the average results in a 10 bp change in redemption value. A variant, the stepped dual index floater, pays a fixed first coupon before reverting to the dual index formula.
LEVERAGED FLOATER/SUPERFLOATER
A floating-rate note whose coupon rises as the reference index which can be in any asset class rises but in a ratio greater than 1. For example, a leveraged FRN might pay a coupon of 2 x (six-month Libor) - 7.09%. This would be the mirror image of an inverse floater. The coupon is floored at zero. The investor is effectively long an FRN of twice the notional principal of the leveraged floater and short a fixed-rate bond whose coupon is the fixed-rate element of the formula. The investor is also usually long floors to prevent negative coupons.
Superfloater characteristics are useful to corporations when structured as superfloater liabilities - the combination of a floating rate liability (that is, borrowing floating) and receiving floating in an interest rate swap of the same notional principal. This structure creates a net coupon of two times Libor less the fixed swap coupon. It might be used by a corporate with an existing liability whose profits fall when interest rates fall, but whose profit losses are greater than any benefits of lower debt funding costs, perhaps because it has little debt.
One extreme example of a leveraged FRN is the power note. This bond or note pays a coupon that is linked to a power of the underlying index. For example, a coupon might be equal to 25.00% minus (3-month Libor)2 with a floor at zero. Investors in these notes want extremely high returns over a short period of time and in return accept extremely large duration and negative convexity. The equivalent investor position is long a fixed-rate note, short a highly leveraged (and changing) amount of FRN, long a highly leveraged (and changing) amount of out-of-the-money interest rate caps.
Leverage can be applied to any structure. Leveraged inverse floaters incorporate swaps of more than twice the notional size of the bond to create coupons such as 12.5% - [2 x (Libor-6%)]. In this case, for every 1% fall in Libor, the coupon of the bond rises by 2% and for every 1% rise in Libor the coupon falls 2%. Since a standard inverse floater is created from an FRN combined with a swap of twice its notional principal, this structure uses a swap of three times the notional principal.
The leveraged capped floater behaves like a normal FRN when Libor (or another index) is below a predetermined strike. Once the index rises above that strike, the note behaves like a leveraged inverse floating rate note. So the schematic coupon (where m is the leverage factor) is Libor + a if Libor < strike; B - m x Libor if Libor > strike. The equivalent investor position is long an FRN, short (m + 1) Libor caps at the initial strike, and long (m) Libor cap options at the higher strike. A typical actual formula might be the minimum of Libor + 30bp and 28.45% less (3 x Libor).
These instruments work best in a steeply positive yield curve environment in that case the caps are priced off the even steeper implied forward curve (and so raise a large amount in premium) and Libor has to move significantly above implied forward rates before the investor's guaranteed pickup is threatened by the formula.
Leveraged structured assets are also known as duration enhanced notes as leveraged formulae tend to create high synthetic positive or negative duration.
PRINCIPAL {coupon} INDEXED NOTE
The generic name for any structured asset whose redemption {coupon} is linked to the performance of one or more assets or reference indices. For example, a currency indexed note's performance is linked to the performance of one or more foreign exchange rates. A typical note might pay no coupon but have redemption formula of 100% x [1 + 150% x (FX - 1.0250)/FX] where FX is the EUR/USD exchange rate at maturity, perhaps with some minimum and maximum redemption levels. Some notes have a further barrier-like condition that would trigger a predetermined redemption level (say 110%) if a particular level were breached at any time by the underlying spot FX rate. Any other asset class may be substituted for foreign exchange and the formula for principal repayment can reflect a long, short or more complex forward or option-related position in the index. The performance of the reference asset(s) can also be linked to coupon payments, leaving principal redemption unchanged/guaranteed (see below) or can affect both coupon and principal.
PRINCIPAL PROTECTED/GUARANTEED NOTES
A fixed-income instrument that offers investors the guaranteed redemption of 100% of the principal plus some, all or a multiple of the rise in value of a particular underlying asset, e.g. a stock index. They are most easily constructed by the purchase of a zero coupon bond whose maturity and nominal value matches that of the capital guaranteed instrument. The difference between the price of the zero and its nominal amount is used to buy options on the desired underlying. The amount of participation in the underlying asset depends on the cash available to buy calls. Falling interest rates push up the cost of the zero coupon bond. This affects the level of gearing that can be offered. Each bank has a name for its own offerings. For example: equity-linked notes (ELNs), protected equity notes (PENs), index growth-linked units (IGLUs), protected equity participations (PEPs), protected index participations (PIPs), equity participation notes (EPNs). Non-equity names include guaranteed return index participations (GRIPs) and guaranteed return on investment units (GROIs).
RATCHET FLOATER
An FRN combined with a ratchet option that pays a high floating coupon subject to a condition that the coupon cannot rise by more than a fixed amount from the previous coupon level nor fall below the previous coupon.The note has a high first coupon of, say, 4.655%. The investor is effectively long an FRN, short a path-dependent or periodic cap and long a path-dependent or periodic floor.
In a steep forward curve environment in which it is implied that rates will rise 2% or 3% in the next year, a cap that protects its holder against any rate rise of more than 25 bp in a quarterly period will be expensive (though not as expensive as a vanilla cap) and so the investors in this ratchet floater will be well compensated for selling it. Equally, the floors the investor is buying will be cheap. This combination allows the note to offer a high coupon floor when although the forward curve is implying sharp rate rises, the investor believes rates may fall or rise much more slowly. The note will severely underperform if rates do rise (particularly for variants of this structure where the coupons are made more generous by the inclusion of a knock-out feature so that if rates rise above the knock-out level the note only pays a nominal coupon). Also known as a one-way floater, one-way collared floater and sticky floater.
REpackaged securities/repackagings
The generic name for securitized asset swaps. The simplest versions are securities issued by a special purpose vehicle that has purchased the underlying bonds and swaps. The asset swaps generate the coupon and principal payments that are passed to investors via the newly issued securities. The use of swaps and other derivatives allows the cashflows of complex securities to be transformed into currencies and structures acceptable to mainstream investors. Overcollateralization of the SPV means that repackaged securities can obtain much higher ratings than the original securities.
Repackagings are used instead of asset swaps for a number of reasons. First, any investors cannot hold derivative instruments directly. Second, asset swaps tie up swap credit lines, expose the buyer directly to the credit of the counterparty, are not easily transferable and can cause accounting difficulties if the asset is trading above par. Because the special purpose vehicle is issuing new securities, it can use a combination of derivatives and structural mechanisms to transform loans into bonds, unrated notes into rated notes, premium into par or discount notes and so on without utilizing investors' swap lines.
Most repackagings incorporate price triggers: if the value of the collateral in the SPV falls below a certain point, the vehicle is unwound and the investors repaid according to the remaining value of the assets and derivatives. In these cases, as with asset swap terminations, the derivative counterparty has a senior claim on the collateral. As with credit derivatives, the investor is exposed both to the credit risk of the underlying assets and the swap counterparty. The incorporation of the unwind trigger creates a similarity between the basic repackaged note and the credit-linked note since an asset swap with an unwind trigger is almost a default swap and a credit-linked note is simply a securitized default swap. The key difference is that the default swap requires an explicit credit event to trigger a credit-related loss to one counterparty while the asset swap requires a price level that may or may not be associated with an actual credit event.
Credit-linked repackaged note combine both a securitized asset swap and a default swap is a . In one structure, a special purpose vehicle purchases a portfolio of assets and any required interest rate and currency swaps, and enters into a credit default swap with a swap counterparty. If a pre-determined credit event occurs in the SPV's portfolio, the trust settles the swap and investors in the notes suffer to the extent that the assets of the portfolio are not sufficient to repay principal and coupon in full. Investors obtain leverage to the extent that the face amount of the portfolio they have exposure to exceeds the face amount of SPV notes. The amount of leverage that can be obtained increases with the credit quality of the portfolio. The difference between this structure and the standard repackaging is simply that the unwind event is explicitly a credit event.
Example
Italian investors are looking for higher-yielding assets than currently available EUR Eurobonds. A bank purchases a portfolio of Argentine Brady bonds and asset swaps the floating USD coupon payment into fixed-rate EUR. The principal exchange on the swap eliminates FX volatility on the currency swap. At the same time the bank enters into a credit default swap with Argentine Brady bonds as the reference assets. In return for an annual fee, the bank undertakes to accept the recovery value of the bonds if a credit event takes place. This is equivalent to undertaking to make a contingent payment to the swap counterparty of the principal value of the credit-linked notes issued against the swap less the recovery value of the Brady bonds. Investors in the CLNs receive a yield around 70bp higher than current Eurobonds.
RE-SETTABLE FRN
The generic name for the combination of an FRN and options to create a note on which the coupons can be reset depending on the performance of some underlying reference asset. For example, an investor's choice FRN is a note plus digital options that pay a conditional coupon. Investors are asked to guess the level of Libor in the upcoming period. If their guess falls within a predetermined range, then they receive an above market coupon. If it falls outside the range, they receive nothing.
RAINBOW NOTE/BOND
A note incorporating a multi-factor option so that the performance of either the principal or coupons is linked to the best performing of a number of assets. So an investor could buy a one-year bond with redemption of 100% plus the best performance out of the S&P 500, 30-year Treasury futures or EUR/USD, subject to a minimum redemption of par. Also known as best-of bond or chooser bond.
TOTAL RETURN [INDEX] NOTES
A bond incorporating a total return swap so that, for example, its coupon consists of the total return from a bond or equity index plus or minus a spread. As most investors cannot incur negative coupons, any negative returns are usually rolled over and, if necessary, deducted from principal at the end. Leveraged structures have been popular with investors - the diagram below illustrates a two-year note embedded with a collateralized five-time leveraged total return swap. The swap generates 200bp plus the price movement on a $50 million loan portfolio. The return to the investor is 6.5% from the collateral plus 10% from the swap assuming no price movement. However, the investor runs the risk of losing principal if the loans fall in value or default.