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6.2.1 The Objective of Even-Smaller Funding Levels

The goal of any treasury desk is to borrow money for the institution in the cheapest possible way, this way lowering the funding cost as much as possible. We have seen that this consists of swapping a bond for the lowest possible asset swap spread. How is this achieved?

An asset swap spread reflects the credit risk of a bond and is proportional to the yield of the bond itself: the more attractive the bond appears to investors, the lower the yield will be. The goal of a treasury desk, the treasury division within an institution, or the debt management agency for a sovereign entity is to find a way of making its debt appear as attractive as possible to investors.

A simple approach, as is the case with many products, is through novelty. By issuing debt in a novel form, an institution not only can issue something scarce and hence valuable, but also something that, being difficult to price in comparison with similar instruments, can gain from some sort of bid-offer premium. In Section 4.2.1 we discussed the bid-offer spread size in relation to liquidity–the wider the spread, the less liquid the instrument. When it comes to selling an instrument, the seller can price it at a higher value than the true value more easily than in the case of a more liquid asset. Using the same terms of comparison, there is a greater gain from selling vintage sports cars than pints of milk. A bond, which is unlike any other bond, will fetch a high price at auction.

We have seen in a previous example, where we used Coca Cola, that a corporate entity usually finds it difficult to issue a bond abroad where its credit standing might seem less appealing to foreign investors than to local ones. While this intuitive reasoning holds in a large number of situations, it is not a general rule. There might be situations where issuing a foreign bond might be to the institution's advantage. If the institution has a particularly good credit standing in general, it might choose to issue a bond in a country where there is a lack of similar institutions of similar standing. The rarity of the bond might make it advantageous to issue in that particular country and foreign currency where the funding level might be even lower than in the institution's own market.

Another possible advantage might come from a choice of maturity. Figure 6.1 shows the debt profile of the USD equivalent outstanding principal value for a few selected borrowing entities: two sovereign, Belgium and Mexico; one supranational, the IBRD; three financials, Societe Generale, Morgan Stanley, and Deutsche Bank; and one manufacturer, Boeing.

The debt profile in time as of October 19, 2011, for a few selected entities.

FIGURE 6.1 The debt profile in time as of October 19, 2011, for a few selected entities.

The first thing we notice, as an aside, is that nonsovereign debt pales in size when compared to sovereign debt. This is true even if it is matched against the one of two countries such as Mexico and Belgium, which are far from being the largest borrowers (to include large borrowers would have meant rendering the graph illegible). This, of course, is partially due to the fact that corporations and financials can raise money through shares; however, in the face of a debt crisis, sovereigns are more exposed.

Leaving the comparison between sovereign and corporates aside, however, what we notice is that the majority of debt crowds the short end of the maturity spectrum, tapering fairly quickly. If an investor wishes to purchase long-dated debt there are not many options and an institution, particularly one in good standing, could try to raise capital at a relatively cheap level by tapping the long-dated market. Immediately we need to state that funding cost, apart from some peculiar exceptions, tends to rise with maturity. This is why we said relatively cheap level: we mean relative to this general upward trend. The attentive reader might have noticed a spike in Societe Generale's debt profile for maturities greater than 30 years: this is due to several perpetual bonds,[1] that is, bonds that have no maturity.

Liquidity would be another factor in a bond price, which could play in favor of the issuer. To issue in an illiquid or exotic currency (particularly if combined with a long maturity) is the equivalent of selling a vintage sports car: the bond could fetch a price well above its true value resulting in a lower cost of funding for the issuing entity. When discussing emerging markets, we mentioned in Section 4.3.1 the role played by development institutions when issuing debt in developing markets' currencies. This brings liquidity and development to the local financial markets but also, through the appetite for good debt in that currency, results in an attractive funding level for the issuing entity.

Complexity is probably the most common element played by issuing entities in order to lower their funding costs. Up to now we have described the coupon on a bond either as fixed or, vaguely, as some function. The nature and complexity of this function plays an important role in the appetite generated by a certain issue. In the same way as a long-dated or an illiquid bond can earn a considerable markup (or markdown in the funding spread), a complex structure in the coupon can render a bond attractive. (Another way of seeing it is by saying that it makes the bond more difficult to value in comparison with other bonds and therefore there is some bid-offer premium.)

We have hitherto defined as Cj a fixed coupon paid at time Tj and as Fj a coupon variable with the value linked either to a floating rate or to a function. This function can be literally anything. The bond coupon might take the form of an equity linked basket option

where we pay at each coupon the average positive performance of a basket of N stocks with respect to a strike K. Such a bond would be very valuable when the correlation between the stocks is high, resulting in the investor taking a long position with respect to equity correlation. It could be a five- year versus two-year constant maturity swap (CMS) spread range accrual of the form

where the coupon consists of a fraction of a fixed value C determined by the number of days, out of a total N in a certain period, in which the five-year swap rate at time 1) is greater than the two-year swap rate at time T. This bond is very valuable in the presence of a steep swap curve, one in which swap rate values grow as the swap maturity grows. It could be a targeted redemption note (TARN) of the form

where Xj is some variable (a stock price, an FX rate, an interest rate, etc.) and K is a target: the bond pays a coupon Xj until the sum of the past coupon payments exceeds a set target K, at which point the principal value of the bond is returned to the investor and the bond terminates.

The above are just examples out of the vast and ever-growing family of exotic structures, the goal of which is to tempt the investor, by offering him exposure to a specific quantity (volatility, correlation, swap curve dynamics, etc.), to pay a higher price for the bond in which the structure is embedded. We are now going to discuss what the impact is of complexity in the value of the funding level/asset swap spread.

  • [1] PerpetuaIs are a very old type of bond (also called rents or consols) that pay a usually low coupon in perpetuity: a little present value calculation will show that this is not as outlandish as it might seem.
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