Puttable-Callable Reset Bonds – A Quack Deal
Sept 23, 2005
In a recent conversation with the Treasurer of a medium sized transnational company (which was in some sort of financial stress) we learnt that the company has recently issued a puttable-callable reset bond to institutional investors, mostly large pension funds and asset managers. The issue size was $500 million (not a small amount) and purpose was to use most of the proceeds to retire an earlier debt. The issue was underwritten by a big investment bank. The really amazing part was that the underwriting fee that the bankcharged the company was ridiculously small. The ostensible reason was that the bank wanted to maintain a very good relationship with the client and at a time of the stress did not want to charge a high fee on the underwriting deal.
Well, the catch was that the same bank was actually the principal in the derivative transaction that was embedded in the deal, i.e. the put option. The details of the deal are:
Issuer: XYZ GmBH
Underwriter: SA Bank
Amount: $500 million
Start Date: January 3, 2005
Settlement Date: January 5, 2005
Maturity: December 31, 2015
Call Date: December 31, 2007
Long Put: SA Bank
Short Put: XYZ GmBH
Strike: ATM (at the money)
Put Underlying 2y UST
Put Notional: $500 million
Put Premium 3%
Put Maturity December 31, 2007
What the treasurer did not tell us but we sort of read between the lines is that the short put was guaranteed, at least partially, by the assets of the company.
A puttable-callable reset bond is a rather simple derivative product which may have disastrous consequences for the issuing companies. Most investment banks love it because this gives enormous flexibility to them to make money.
In the above deal the issuer company sells a 10 year callable bond to the investors, which is underwritten by the bank and at the same time sells a two year put option on the 2 year US Treasury Bond. The bond can be called back after two years. The 2-year at the money (ATM) put was priced at 3%. This, in our opinion is the deal breaker for the issuer. The premium of the put option is very low and obviously the bank had grossly (and shall we say, deliberately?) mis-priced the option. A further interesting feature of the transaction was that the bank did not pay the premium to the issuer up-front, as an option buyer should do, but rather the terms specified that the option will be cash settled two days after the maturity date (two years hence).
In fact, this rather bizarre transaction was premised on the mis-pricing of the put option underlying the callable bond in conjunction with the bank’s sure shot bet on falling short term rates in the U.S. The callable bond was priced properly and sold to the investor and by charging almost nothing from the issuer as underwriting fees, the bank stood to make nothing from the deal. However, it did buy a put option from the issuer at the same time, with the same maturity of the embedded call in the bond. And that put option was bought for no upfront cash payment and at a steeply discounted (to the fair value) price.
US interest rates are likely to rise and bonds markets are likely to experience sharp decline. We are pretty sure the bank is betting on this scenario. Say, after two years, on the maturity date of the put option (which would also be the call date on the bond) the value of the option is 10% of the face value of the bond. This is quite possible if the interest rates in the U.S. rise really sharply over the next two years and bond prices plummet. If this happens then the company would need to cash settle the option and 7% of the notional is around US$35 million. The company will be required to pay this amount to the bank. This amount may significantly affect the P & L of the company and the hit could be disastrous especially if the company continues to remain in financial stress because of internal and external factors.
he bank on the other hand would earn 7% from the long put option which would be substantially (and unimaginably) higher than what it would earned from any normal underwriting fees. And if our reading of the situation was correct, then the
bank can force the company to sell assets to pay for the cash settled amount of the put option, which sort of acts a guarantee for the amount if the option is in the money.
In the event that the put option is in the money and the company cannot pay the difference in the premium to the bank (for whatever reasons) then the bank can call the bonds back from the investors and re-market (after repackaging) it by putting an above market coupon on the bond, say $107 instead of $100, and only passes on $100 to the issuer (company) and keeps the $7 to offset the put option premium. This is why the word “reset” appears in the name. But we strongly doubt that the bank will do this, as there is very little incentive to do it. There is simply no market for this anymore.
Of course, the US interest rates may not rise at all and the put option may finish out of the money, which will then be the end of the matter and the company can then go on and either call the bond or live with it for the rest of the term. But that is the risk that the bank is taking in this deal.
We must admit, this is a rare transaction. We were under the impression that such transactions, puttable-callable reset bonds, are no longer in vogue.
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