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SEEING THROUGH THE ILLUSIONS
IN STRUCTURED FINANCE–PART II
Prepared by Technical Data
A Division of Thomson Financial Networks
This article will take a closer look at a $100 million, five-year note issued by FHLB (Federal Home Loan Bank) on October 16, that was callable one time only, one year after issuance. In review, the note was issued at par with a yield of 6.42% or 46 basis points (bp) over the on-the-run five-year Treasury note. By contrast, FHLB could have issued a non-callable five-year note at an option adjusted spread (OAS) of only 12.5bp over the five-year Treasury, or a yield of 5.965%. Comparing the OAS to the full spread of the callable note makes it possible to value the call embedded in the note at 33.5bp. To look at it another way, the 46bp over Treasurys for the call spread can be decomposed into a call value of 33.5bp plus an OAS of 12.5bp.
FHLB is known for issuing callable debt with the intent of swapping it into attractive floating rate debt indexed to LIBOR. The swap market provides the mechanism and economic motivation to do so. A derivatives dealing bank will write a swap to pay a fixed rate to FHLB to fund the coupon on the callable note that FHLB must pay to the investors. In return, FHLB will pay a floating rate payment to the bank at some spread under LIBOR. Because of their AAA credit rating, most agencies can already fund on a floating rate basis at around LIBOR minus 12bp. These values serve as the benchmark that FHLB must exceed in a swap if they want to procure a lower cost of funds. The generic commercial bank swap counterparty typically reflects a credit rating of about AA+, which (in mid-October) equated with a five-year fixed swap rate being priced at a spread of 36bp over the five-year Treasury note. This means that FHLB has a comparative credit advantage which will contribute to the end result of the swap.
FHLB also has the advantage of being able to acquire a relatively cheap call option from the investors who reside at the bottom of the option food chain. In the swap, the call embedded in the note becomes monetized by repackaging it at a mark up and selling it as an option on the swap (i.e., a swaption). The profit from re-sale of the option also contributes to the swap by helping to subsidize FHLB's floating rate LIBOR payment. Assumptions about interest rate volatility are essential to option pricing and this can be measured with the help of an option pricing model. Thus, the 33.5bp embedded call value equated to an implied interest rate volatility of 11.32%, (the higher the volatility, the greater the option value). However, volatility quotes in the over-the-counter swaption market at the time of issuance was more like 14.90%. This equates with an option value of 29bp, not quite as much as the embedded call because the 6.42% coupon on the note translates into a higher value for a call priced off the agency yield curve than one priced off the LIBOR swap yield curve because of the credit differential. Nevertheless, when the 29bp option value is added to the 36bp five-year swap spread, it results in a combined value of 65bp over the five-year Treasury compared with the call spread on the note of only 46bp.
The swap could be constructed in one of two ways: a five- year swap paying a fixed rate of Treasurys plus 65bp to FHLB versus receiving LIBOR that can be canceled (i.e., called) in one year, otherwise known as a receiver swaption. This receiver swaption will be canceled in one year if rates have fallen, which in turn will trigger the calling of the note. Alternatively, the swap could take the form of a one-year swap paying a fixed rate of Treasurys plus 65bp against LIBOR with the option to be extended to the full five- year maturity, otherwise know as a payer swaption. Conceptually, a payer swaption is analogous to a put option, (right to sell), on a bond and it will be exercised if interest rates have risen, in which case the note won't be called. Either way, FHLB would theoretically receive a fixed payment of 6.61% (Treasurys plus 65bp) on the swap and pay LIBOR minus say 12bp. The 6.61% fixed payment received from the swap pays the 6.42% liability on the note, leaving a 19bp savings. The result after factoring this savings into the floating rate leg of the swap (including the underwriting fees of about 4bp) produces a net cost of funds of LIBOR minus 27bp. In practice however, the swap counterpart would simply pay FHLB a fixed rate of 6.42% to match the coupon in the note, and transfer the 19bp savings less fees to the floating rate leg of the swap.
December, 1997Ed Rombach, Derivatives Specialist
Technical Data
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