Can Synthetic Debt Five Authentic Savings?

• Author: Leib, Barclay T.

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...