Can Synthetic Debt Five Authentic Savings?

Putable/callable reset bonds. Term-enhanced remarketable securities -- or TERMS, for short. These products may carry different names at different Wall Street investment banks, but if you're a corporate treasurer, and you haven't been exposed to a marketing pitch on putable/callable synthetic debt, consider yourself the exception. Putable/callable reset bonds are red hot.

According to literature from Credit Suisse First Boston, U.S. corporations have issued more than $45 billion in "synthetic putable" debt since 1996. The driving force behind these products' popularity has been the twin combination of low interest rates and high implied volatilities in the fixed-income option market. More recently, a contributing factor has been the relatively wide swap premiums for long-dated corporate debt that many treasurers are unwilling to pay on a simple outright basis.

Here's how the product specifically works. XYZ Corporation is going to issue some debt. The company is relatively indifferent between issuing 2-year paper or 10-year paper, but very concerned with keeping its funding costs as low as possible.

Enter a Wall Street structurer. He or she invents a security that typically has a 10-year nominal horizon but some special put and call features two years out. Specifically, the investor in this paper, via a trustee, has a mandatory obligation to put the paper back to the issuer in two years if interest rates go up, and the investment banker has the right to call the paper and remarket it to the public as a new 8-year security if interest rates go down.

Sound complicated? Actually, it's not really complex. Because the security either gets put or called in two years' time, no matter what interest rates do in the interim, what the company effectively has issued is a two-year bullet obligation to the put/call date. The only tricky part of the product is that to lower up-front funding costs, the company has also effectively sold its investment banker a call on a hypothetical 10-year treasury security.

If rates go up, the debt issuer pockets the premium on this call option, effectively lowering funding costs for the first two-year borrowing period. If rates go lower, the company will owe its investment banker some money on the hypothetical T-note call option sold. But the investment banker then graciously promises to roll this loss into a new issuance of bonds. In the remarketing process, a new price and coupon are determined by the market that will not only extend the debt another eight years, but will also pay off the intrinsic value on the issuer's previously short call option position.

Many corporations, including Nabisco Group Holding Corp., General Motors Acceptance Corp., Bell South Corp., Texas Utilities Co. and Ford Motor Credit have used these products. The first wave of putable/callable debt excitement blossomed in 1996, but carried on well into 1998. In that, latter year, Canadian National Railway Co., while considering financing alternatives to acquire Illinois Central, decided that it liked the idea so much, it would push the whole maturity structure out even further. That company issued $250 million of 38-year debt with a put/call feature eight years forward. Later that same year, Ford Motor issued $375 million with a 13-year time horizon that has its put/call reset date coming up this October.

The great attraction of putable/callable debt is the comparative cost of funds once one adds in the premium receipt on the embedded short call option. In CSFB's brochure, for example, the firm discusses a 12-year bond with a 2-year put/call date. In this example, on a terminal break-even basis, the corporate treasurer doesn't know whether he or she will end up with 2-year money at 4.56 percent or 12-year funding at the equivalent of 6.32 percent, but in either case, the company's cost of funds will be lower than the current straight 2-year rate of 5.41 percent or 12-year paper at 6.90 percent. It would appear to a neophyte that you'd save approximately 60 basis points either way.

The rub, of course, is that for the 60-basis point savings, the corporate issuer always ends up with the least advantageous long-term position. If rates go up and it turns out the treasurer should have borrowed long, another round of financing will be needed in two years' time. If rates go substantially lower, the treasurer is effectively locked in from the short treasury call to the equivalent of having already issued long-term securities.

In the latter instance, the treasurer will also still face a somewhat nebulous refinancing situation when the reset hits. What happens if interest rates have plunged and the corporation owes the investment banker $20 million in intrinsic value on the short T-note call? That cost will have to be built into issuing a new piece of paper at a sufficiently high above-market interest rate so as to be issued at a premium to par, and thereby maintain the corporation's funding while also reaping enough money to pay back the investment banker. If the corporation's credit spread to the market has deteriorated in two years, that, too, could cause added problems.

The problem the investment banker is unlikely to highlight to the issuer up front, however, is that this subsequent debt issued significantly above par almost always must carry a 10-15 basis-point yield enhancement in order to attract buyers. If remarketing is necessitated, this means at least part of the up-front cost savings the treasurer thought the putable/callable reset bonds offered will be lost. In addition, this added cost would also be spread out over a far longer period.

"For this reason, the majority of putable/callable bonds that have been in the money don't actually get remarketed," says one investment banker. "To date, the majority have simply been retired with a cash settlement to the investment banker, or exchanged for a whole new issue of debt carrying a greater notional value." In other words, instead of issuing 10-year debt for $100 million carrying an off-market interest rate so as to be issued at 105, companies tend to issue new bonds at par totaling $105 million and carrying a market rate. The extra $5 million received then goes to the investment banker to settle the in-the-money option that the corporation had previously been short.

Some might ask why the investment bankers don't simply provide for such a debt exchange explicitly in a bond's initial prospectus -- if indeed this is the route many companies follow. The answer is that the SEC does not allow language in any prospectus that potentially changes a notional amount of debt outstanding. It can only be changed after the fact via a completely new issue.

Others might ask just what FAS 133 problems putable/callable bonds potentially raise. But in actuality, and courtesy of an interpretation from the Financial Accounting Standards Board's Derivatives Implementation Group (DIG) last year, the answer is none. Although a cloud of uncertainty hung over putable/callable bonds with the approach of FAS 133 implementation in late 1999, the DIG eventually ruled that because the embedded short option relates to interest rates, as does the underlying price behavior of the bond, there is no need for a corporate issuer to mark the sold embedded Treasury option to market, After this proclamation, new putable/callable bond issuance boomed.

But there is a second small problem that corporations often ignore: the tax consequences of these products. Let's assume a company issues 10-year debt with a 2-year put/call reset that normally would have carried a 6.6 percent yield for an all-in cost of 6.0 percent. The nominal coupon on the debt might still read 6.6 percent, and the 60 basis points would come from a separate payment to the corporation by the investment banker. If, after two years, the short option ends up out of the money, the company must book a windfall gain on this short option, and this windfall is taxable as income.

This leaves the company having paid 6.6 percent and receiving something less than 60 basis points net of taxes for the short option risk. The after-tax cost of funding is actually higher than the advertised 6 percent rate. Meanwhile, if the option is in the money and at a loss, the added cost that the company is out of pocket can only be amortized over the subsequent 8-year stub period of the paper -- not a great deal.

In short, corporations, looking at terminal break-even spreadsheets may think these products look sexy and attractive on an up-front basis, but there are a few uncertain backdoor costs. In addition, though rates may seem low to most corporate treasurers at present, there is also still the risk of suffering a true black eye if rates were ever to fall to super-low levels in the United States as has happened in Japan over the past decade.

Many derivatives-savvy treasurers recognize some of these pitfalls. "I have seen a number of these structures presented to me," says one consumer goods company treasurer, "but I honestly don't like these things. At the end of the day, they represent a speculative instrument and an additional bet on the direction of interest rates that I just don't need."

But elsewhere, a more general attitude has been: Why not sell that extra option, get cheap money for a few years, and worry about the resetting exposure later on? "We didn't understand this product at first" says one Ontario-based treasury staff member. "We studied it, ran the numbers, and, in the end, we liked the comparative interest rate savings we could achieve. We'll worry about the resetting when we get there."

In the case of Nabisco, assistant treasurer Benjamin Boykin, working under former Nabisco Treasurer Frank Souzzi, agreed to issue a boatload of these bonds a few years ago. But Nabisco has since been acquired by Philip Morris Cos., Inc. Now it's someone else's problem if these securities have gone awry on the back end, as it appears may have occurred. Andrew Kalotay, president of consultant Kalotay Associates believes Nabisco would have faced a $100 million mark-to-market loss had the DIG ruled that putable/callable reset bonds needed to be bifurcated and marked to market. Instead, Philip Morris' funding costs will now run just a tad higher than they otherwise would have been had Boykin previously been less impetuous.

Overall, one thing is for sure: If interest rates ascend from here, all the treasurers currently hopping on putable/callable bonds will outwardly appear pretty smart. They will have raised relatively cheap money with no added pain. But if rates decline, a few back-door surprises may still lurk. Given the pace at which treasury officials sometimes move around internally or switch firms, maybe this doesn't matter much. But when your friendly bank structurer comes touting the next greatest thing since sliced bread, be sure you understand that there's often a hitch.

Barclay T. Leib is the president of Sand Spring Advisors LLC, a New Jersey-based financial consulting and alternative asset management company.