Appendix A

SUMMARY OF BANK PRODUCT LINE

As part of the introduction to banking we provide a summary of the product line offered by banks. Not all banks offer all these products, but these instruments are available in virtually every banking market. More detailed information is available in the author’s books The Money Market Handbook, Fixed Income Markets and Bank Asset and Liability Management, all published by John Wiley & Sons (Asia) Pte Ltd.

Interest-bearing and non-interest-bearing current accounts

These are also known as cheque accounts or (in the USA) checking accounts; they are the simplest form of short-term deposit or investment instrument. Customer funds may be withdrawn instantly on demand and banks generally pay interest on surplus balances, although not in all cases. Current accounts are a cheap source of funding for banks, as well as a stable one, but the funds are less valuable from a liquidity metrics point of view because their balances are instant access.

Demand deposits

Also referred to as sight deposits, they are similar to cheque accounts but are always interest bearing. The funds are available on demand, but cannot be used for cheques or other similar payments.

Time deposits

Time or term deposits are interest-bearing deposit accounts of fixed maturity. They are usually offered with a range of maturities ranging from 1 month to 5 years, with longer dated deposits attracting higher interest. This reflects the positive yield curve, which indicates the funding value to the bank of longer term liabilities. Most time deposits pay a fixed rate of interest, payable on maturity. Accounts of longer than 1-year maturity often capitalize interest on an annual basis.

Government bonds

The secondary market in government bonds is provided by banks that choose to be market-makers or primary dealers. Sovereign debt is essentially a plain vanilla market, with the vast majority of bonds being fixed coupon and fixed maturity. Governments also issue index-linked bonds which offer return linked to the rate of inflation.

Floating rate notes

Floating rate notes (FRNs) are bonds that have variable rates of interest; the coupon rate is linked to a specified index and changes periodically as the index changes. An FRN is usually issued with a coupon that pays a fixed spread over a reference index (e.g., the coupon may be 50bp over the 6-month Libor rate). Since the value for the reference benchmark index is not known, it is not possible to calculate the redemption yield for an FRN. Additional features have been added to FRNs, including floors (the coupon cannot fall below a specified minimum rate), caps (the coupon cannot rise above a maximum rate) and callability.

Generally, the reference interest rate for FRNs is the London interbank offered rate or Libor. An FRN will pay interest at Libor plus a quoted margin (or spread). The interest rate is fixed for a 3-month or 6-month period and is reset in line with the Libor fixing at the end of the interest period. Hence, at the coupon reset date for a sterling FRN paying 6-month Libor0.50%, if the Libor fix is 7.6875%, then the FRN will pay a coupon of 8.1875%. Interest will therefore accrue at a daily rate of 0.0224315.

On the coupon reset date an FRN will be priced precisely at par. Between reset dates it will trade very close to par because of the way in which the coupon is reset. If market rates rise between reset dates an FRN will trade slightly below par; similarly, if rates fall the paper will trade slightly above. This makes FRNs very similar in behaviour to money market instruments traded on a yield basis, although of course FRNs have much longer maturities. Investors can opt to view FRNs as essentially money market instruments or as alternatives to conventional bonds. For this reason we can use two approaches when analysing FRNs. The first approach is known as the margin method. This calculates the difference between the return on an FRN and that on an equivalent money market security. There are two variations on this: simple margin and discounted margin.

Letter of credit

A letter of credit (LoC) is a standard vanilla product available from a commercial bank. It is an instrument that guarantees that a buyer’s payment to a seller will be received at the right time and for the specific amount. The buyer is the customer of the bank. If the buyer is unable to make payment on the due date, the bank will cover the full amount of the purchase. The bank therefore takes on the credit risk of the buyer when it writes an LoC on the buyer’s behalf. The buyer therefore pays a fee for the LoC that reflects its credit standing.

LoCs are used in domestic and international trade transactions. Cross-border trade transactions involve both parties in issues such as distance, different legal jurisdictions and lack of any available due diligence on the counterparties. An LoC is a valuable tool that eases the process for the buying and selling parties. The bank also acts on behalf of the buyer (the purchaser of the LoC) because it would only make payment when it knows that the goods have been shipped. For the seller, an LoC substitutes the credit of the buyer for that of the bank, which is an easier risk exposure for the seller to take on.

There are essentially two types of LoC: commercial and standby. A commercial LoC is the primary payment mechanism for a transaction, while a standby LoC is a secondary payment mechanism.

Commercial letter of credit

A commercial LoC is a contract between a bank, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank makes a commitment to guarantee drawings made under the credit. The beneficiary is normally the provider of goods and/or services. An advising bank, usually a foreign correspondent bank of the issuing bank, will advise the beneficiary but otherwise has no other obligation under the LoC.

An LoC is generally negotiable; this means that the issuing bank is obliged to pay the beneficiary but – should the issuing bank so request – any bank nominated by the beneficiary could make the payments. To be negotiable, the LoC features an unconditional promise to pay on demand at a specified time.

Standby letter of credit

A standby LoC is a contract issued by a bank on behalf of a customer to provide assurances of its ability to perform under the terms of a contract between it and the beneficiary. In other words, a standby LoC is more of a guarantee, as both parties to the transaction do not expect the LoC will be drawn on. It essentially provides comfort to the beneficiary, as it enhances the creditworthiness of its customer.

Structured deposits

A structured deposit is a deposit whose payoff or return profile is structured to match a specific customer requirement. The structuring results from the use of an embedded derivative in the product, which links the deposit to changes in interest rates, FX rates or other market rates. There is a wide range of different products available that fall in the class of ‘structured deposit’. An example is the following: a customer places funds on deposit at a specific interest rate and fixed term. Under the agreement, if the central bank base interest rate remains between 4% and 5%, then return is enhanced by 100bp. If the rate moves below 4% or above 5%, then the deposit forfeits all interest for the remaining term of its life. This is an example of a ‘collared range accrual’ deposit.

Liquidity facilities

Liquidity facility is the generic term for a standing loan agreement, against which a borrower can draw down funds at any time up to the maximum value of the line. The borrower pays a fee, called the standing fee, even if the line is not used and then pays the agreed rate of interest on any funds that it does draw.

We distinguish between the following:

• Back-up facility. A facility that is not used in the normal course of business. It is generally drawn down if the borrower is experiencing some difficulty in obtaining funding from its usual sources.
• Revolving credit facility (RCF). A commitment from a bank to lend on a revolving basis under pre-specified terms. Under an RCF there is usually a regular drawdown and repayment of funds during the life of the facility.
• Term loan. This is distinct from liquidity lines in that it is a non-revolving facility and will be drawn down at execution. It has a fixed repayment date, although this may be on an amortized basis.

Liquidity facilities require full regulatory capital backing, as the capital treatment is to assume that they are being used at all times.

Syndicated loans1

To raise debt capital, companies may issue bonds or loans (as well as other debt-like instruments), both of which are associated with a certain seniority or ranking. In a liquidation or winding up, the borrower’s remaining assets are distributed according to a priority waterfall: debt obligations with the highest seniority are repaid first; only if assets remain thereafter are obligations with lower seniorities repaid. Further, debt instruments may be secured or unsecured: if certain of the borrower’s assets are ring-fenced to serve as collateral for the lenders under a particular obligation only, this obligation is deemed to be ‘secured’. Together, seniority and collateral determine the priority of an obligation. As illustrated in Table A.1, bonds and loans issued by investment-grade companies, as well as bonds issued by sub-investment-grade companies, called ‘high-yield bonds’, are typically senior unsecured. However, loans issued by sub-investment-grade companies are typically senior secured. Often, these are called ‘leveraged loans’ or ‘syndicated secured loans’. The market often uses both terms interchangeably.

Table A.1 Typical priorities of corporate bonds and loans of investment grade and sub-investment-grade borrowers

The definition of ‘leveraged loan’ is not universal, however. Various market participants define a leveraged loan to be a loan with a sub-investment-grade rating, while other users view it as one with a certain spread over Libor (say 100bp or more) and sometimes a certain debt/EBITDA ratio of the borrower. S&P, for instance, calls a loan ‘leveraged’ if it is rated sub-investment grade or if it is rated investment grade but pays interest of at least Libor125bp. Bloomberg uses a hurdle rate of Libor250bp. Essentially, the market refers to leveraged loans and high-yield bonds as ‘high-yield debt’.

Leveraged loans may be arranged either between a borrower and a single lending bank, or, more commonly, between a borrower and a syndicate of lending banks. In the latter case, one (or more) of the lending banks acts as lead arranger. Before any other lending banks are involved, the lead arranger conducts detailed due diligence on the borrower. Also, the lead arranger and borrower agree on the basic transaction terms, such as size of the loan, interest rate, fees, loan structure, covenants and type of syndication. These terms are documented in a ‘loan agreement’. Based on the information received in the due diligence process, the lead arranger prepares an information memorandum, also called the ‘bank book’ which is used to market the transaction to other potential lending banks or institutional investors. Together, the lead arranger and the other lenders constitute the primary market. If the transaction is an ‘underwritten syndication’, the lead arranger guarantees the borrower that the entire amount of the loan will be placed at a pre-defined price. If the loan is undersubscribed at that price, the lead arranger is forced to absorb the difference. If the transaction is a ‘best efforts syndication’, the lead arranger tries to place the loan at the pre-defined terms but will, if investor demand is insufficient, adjust these terms to achieve full placement.

Leveraged loans are usually secured by particular assets of the borrower. These assets are listed in the loan agreement and may comprise all tangible and intangible assets of the borrower. This means that, in the event of default, lenders can take possession of these assets, liquidate them and use the proceeds to satisfy their claims in the order of priority stipulated in the loan agreement and the related inter-creditor agreement. This happens before the claims of any unsecured lenders are satisfied.

Leveraged loans typically consist of a revolving credit facility (or ‘revolver’) and ‘term loans’. Term loans are usually tranched into an amortizing term loan (term loan A), provided by syndicate banks, and institutional tranches (term loans B, C and D), provided by institutional investors. In the US market, amortizing term loans have become increasingly rare as institutional investors are now the primary buyers of leveraged loans. Term loan D may represent a further subdivision, called ‘second-lien tranche’, which is subordinate to term loans A, B and C (called ‘first-lien tranches’), but ranks senior to all other debt of the borrower. Historically, this structure has resulted in significantly higher recovery rates of first-lien tranches compared with second-lien tranches.

Term loan A is usually repaid on scheduled repayment dates during its life, whereas term loans B, C and D are mostly subject to bullet repayment (i.e., a one-off repayment on the maturity date). Once repaid, term loans cannot be re-borrowed. This is the principal difference from the revolving credit facility, usually provided by syndicate lenders, which allows the borrower to borrow, repay, and re-borrow funds during the life of the loan in accordance with predetermined conditions. In addition to interest on borrowed funds, borrowers are charged a commitment fee on unused funds. Revolvers are often used to fund working capital and capital expenditure requirements that can fluctuate significantly over time. Table A.2 summarizes this discussion.

Table A.2 Typical structure of leveraged loans

Leveraged loans pay floating rate coupons. These are composed of Libor (or another inter-bank rate, depending on the loan’s currency), plus a certain spread (i.e., risk premium); typically, they are payable quarterly. Floating rate coupons provide an effective hedge against interest rate risk: if interest rates rise, so does the coupon and vice versa. Consequently, floating rate coupons are particularly popular in times of rising interest rates. Often, the spread of leveraged loans is not fully fixed but moves according to a pricing grid pre-defined in the loan agreement: if the borrower’s credit condition improves (e.g., indicated by a decline in financial leverage and/or a rating upgrade), the spread decreases and vice versa.

Leveraged loans commonly mature between 7 to 10 years after issuance. The effective life of leveraged loans, however, tends to be significantly shorter as the borrower is typically allowed to prepay or ‘call’ the loan at any time at no premium or a limited premium. Prepayment is generally seen as a negative by lenders. This is because borrowers tend to prepay when their refinancing costs decrease; for instance, when they are upgraded to investment grade or acquired by an investment-grade-rated company or when interest rates decrease. For lenders, this means that they bear all the downside (i.e., rising interest rates or a deterioration in the borrower’s credit condition) but retain a limited upside. As mentioned, floating rate coupons mitigate lenders’ risk associated with rising interest rates. To some extent, pricing grids can do the same for the risk associated with a deterioration in the borrower’s credit condition.

REFERENCE

Choudhry, M. (2007). Bank Asset and Liability Management, Singapore: John Wiley & Sons.

1 This section is an extract from chapter 11 of the author’s book Structured Credit Products: Credit Derivatives and Synthetic Securitisation, 2nd edition, John Wiley & Sons (Asia), 2010. This chapter from the author’s book was co-written with Timo Schlafer and Marliese Uhrig-Homburg.