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1.3 BORROWING

The type of development institutions we are concerned with are those (we discuss them in more detail later) that use the tools of investment banking toward development, that is, they use their superior credit to borrow in the capital markets and then use the funds raised toward lending.

The debt profile of a development institution is one that should at the same time be in tune with its income profile (by income profile we mean the types of loans issued as discussed in the previous section) and capable of maximizing investors' needs. We shall discuss this at great length in the following chapters but, it is almost obvious, a bank should issue debt that can be considered as attractive as possible in the eyes of investors, otherwise not only will it be difficult to place, it will also be unduly onerous to serve.

In a way similar to the one adopted in the previous section we give a brief and informal description of the type of choices an institution has to make when it comes to funding through debt. The description is informal in that all mathematical and/or rigorous formalism is left for later parts of the book.

┠Currency of debt: In the previous section we mentioned that any financial player tries to match the currency of its debt with the currency of its income. A development bank issues loans in at least a few strong currencies and, as we have seen, in some cases also in weak currencies. Assuming that for any institution there is only one mother currency, the other currencies, weak or strong, need to be obtained in order to be subsequently disbursed in the form of a loan. This could happen either by converting the institution's principal currency to the currency needed for the loan or, as in most cases, by issuing debt in that currency.

Issuing debt in a specific currency not only has the advantage of matching the currency of a loan but also, as we shall see more formally in Section 6.2.1, has the advantage of exploiting investors' appetite for the institution's debt. Let us consider development bank ABC, which has a certain credit rating and is USD centered, meaning that its main currency of business is USD. Let us assume that in the United States there are other institutions similar to ABC, both in nature and in credit standing, but in Japan there are none. This absence results in a great interest on the part of Japanese investors for debt of ABC's kind. It would make sense for ABC to issue debt in Japanese Yen (JPY) since, all things considered, it would receive more favorable terms.[1] Now, ABC is in possession of a certain amount of JPY, which is not only needed for a loan, but results in an advantageous servicing of debt from its own point of view.

┠Profile and tenor of debt: The careful balance between a bank's cost and income shall be treated rigorously in Chapter 7, however, it is quite intuitive to imagine that, the same way we would like to match the currency between debt and income, it would be ideal to try to match the tenor and general structure of our debt and our loans. As we shall see later, this turns out to be rather complicated.

We mentioned in the previous section that bullet loans are extremely rare. It turns out that amortizing debt in the form of bonds with an amortizing principal profile is also rare. This means that there is an initial and fundamental mismatch in the principal profile of the debt issued by the institution and the income it receives in the form of loans. In Section 3.1.1 we shall attribute this difference principally to the fact that bonds tend to be securitized instruments as opposed to the overwhelming over-the-counter nature of loans. A second fundamental difference is driven by credit. It is almost a universal truth that borrowing over the short term is cheaper than borrowing over a longer one. Since, despite being not-for-profit organizations, development banks have some fixed costs and cannot operate at a loss, they are obliged to have a shorter average maturity for debt than for loans. This is what ensures, in principle, a small positive net income. However this also ensures that, as far as maturity and principal amortization are concerned, bonds and loans will never be matched and this can lead to serious risks.

┠Fixed or floating rate: The choice, on the part of an institution, to issue fixed- or floating-rate debt is driven, like the one of currency, by a balance between the borrower's need and the investors' appetite. As in the case of a loan, a fixed-rate bond is one where the investor receives the same percentage amount of principal at regular intervals and a floating- rate bond is one where that amount is variable and is linked to some external parameter. Although, as we said, the tendency on the part of the lender (i.e., the bank) is to prefer the disbursement of floating-rate loans, there could be situations in which, in response to great investors' interest in a hxed-rate bond, the bank is in the situation in which the fixed-rate nature of the loan matches the one of the bond.

Vanilla or exotic: A debt instrument can be anything in terms of complexity. It can be a bond paying a simple coupon (fixed or floating), it can be a coupon offering the payout of a simple option (a call or a put on a familiar[2] underlying), or it can be a coupon linked to the payout of an exotic option, that is, an option whose payout is complex and needs a serious computational effort in order to be priced. These payouts can include a combination of caps, floors, values linked to past performances (look-back features), spreads, and so forth. The reason behind the choice of more or less complexity, that is, more vanilla or more exotic, in the type of debt issued is linked to a search for more attractive funding levels. This will be explored in detail in Section 6.2.1.

Debt managing tools: We have mentioned quite a few times the concept of matching. Ideally a development bank would try to make sure that the nature (in terms of amortizing profile), currency, and fixity of rate of its debt is similar to the one of its income, that is, its loans. This, we have seen, is not always possible. We have also said that development banks are generally risk averse and prefer to be exposed to the smallest number of financial variables. A development bank would usually choose one currency and one type of rate and take them to be a measure of all things, so to speak. A U.S.-based development bank would, for example, choose USD to be its principal currency and a certain floating rate, for example, the LIBOR rate resetting every six months, to be its principal rate. (We have not defined the LIBOR rate yet, but for the rest of the chapter we shall simply treat it as some generic variable rate.) This means that all income and all debt that does not match the USD six-month LIBOR profile needs to be converted into it. A USD fixed-rate loan would need to be converted into a similar floating-rate loan, then the bank would seek to enter into a contract with some other party in which it pays the fixed rate received from the loan and receives a floating rate in return. A similar, if opposite, situation would be needed to convert a USD fixed- rate bond. The bank would enter into a contract paying a floating rate in USD and receiving the fixed-rate coupon in USD, which goes on to the investor. What applied to fixity also applies to currency. Should the loan be fixed (or floating) in, say, EUR, the bank would seek to enter into a contract in which it would pay another party the fixed (or floating) coupon in EUR it receives from the loan and it would obtain in return a floating payment in USD. A similar, if opposite, contract would be needed to convert a fixed (or floating) rate bond in EUR. These types of subsequent contracts are known as swaps and will be discussed at length later.

  • [1] We shall give a formal definition of what “all things considered” means when discussing asset swap spreads when we shall also be able to understand formally what we grasp intuitively as to the meaning of “favorable terms.”
  • [2] By familiar we mean interest rate, equity, or FX: although the term familiar is not a standard one, even a simple option linked to credit or commodities would probably not be considered so simple.
 
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