Bank A has been given the opportunity to buy a large number of US dollar-denominated bonds issued by Energy Enterprises (EE), a triple-B rated British utility company. This would amount to a principal amount of $100 million—but the bonds are currently trading in the market at a discount.
The bonds carry a fixed annual-pay coupon of 6 per cent and have exactly five years to maturity—so the first coupon you will receive from buying the bonds is one year away. There is no accrued interest.
The bonds are being offered to Bank A at 84.837 per cent of par. At this price, the yield-to-maturity on the bonds is 10 per cent.
Unfortunately, Bank A, although interested in the opportunity, would want to hold a floating rate asset, not a fixed-coupon bond.
However, the Investment Bank (IB) has offered to repackage the bonds for Bank A as synthetic floating rate notes via a special purpose vehicle.
The deal is as follows: Bank A will provide $100 for each bond purchased and will receive LIBOR, as the floating rate, plus a 20 basis points spread (0.20 per cent) over the reference rate for the five years, plus a repayment of the $100 principal at maturity. These floating rate payments will take place at the end of each year (i.e. annually) to match the payments on the bond and up to and including the final maturity at the end of year 5.
The terms and conditions in the US dollar interest-rate swaps market are given below:
Maturity Par swaps rate against LIBOR
1 Year 9.50%
2 years 9.59%
3 Years 9.62%
4 Years 9.69%
5 Years 9.70%
Question: Why would Bank A rather hold a floating rate asset issued by EE rather than the fixed rate bonds.
I understand that it is designed to provide an attractive level of income as conventional bonds, which pay a fixed coupon typically suffer in a rising interest rate environment.
In this sense, the instrument would pay a variable coupon (regularly adjusted in line with short-term interest rates) giving Bank A protection and a way of benefiting from any future increase in interest rates. Am I close?
The best time to buy floating-rate bonds is when rates are low, or have fallen quickly in a short period, and are expected to go up.
I’m still a bit confused with the synthetic floating rate note offer for value. I’m not really sure how to explain if cash flows of this transaction add or do not add up.
The “. . . are low, or have fallen quickly in a short period, and . . .” part isn’t necessary; what matters is what’s left: “The best time to buy floating-rate bonds is when rates are . . . expected to go up.”
So the answer to the question, “Why would Bank A rather hold a floating rate asset issued by EE rather than the fixed rate bonds?” is that, presumably, Bank A expects rates to increase.
Oh.
I thought that the question you had bolded was the one you wanted answered.
Are the rates in your table swap rates, or spot rates, or par rates, or . . . ?
As we’re talking about a 5-year bond, we’re interested in the 5-year swap rate: 9.70%. What this means is that if you enter into a 5-year swap, given the current yield curve, your yield will be 9.70%. As their offer is 20 bp above that, your yield will be 9.90%
Is that better or worse than your yield on the fixed-rate bonds?
Hi. So since the floating rate offer on the swap is LIBOR + 20bp, the yield on the swap is 9.90%. However, the yield-to-maturity on the fixed-rate bonds is 10%. Therefore, Bank A is losing out from entering the swap transaction, even though they have exchanged a fixed asset for a floating asset.
Following on from my previous question, how do we determine the fixed rate on the swap that Bank A has to pay? Do they pay the 6% coupon or the 10% yield-to-maturity? Or just the 9.7% par swap rate? This is taking into account that these bonds are not being sold at par
