Sls backed mtn ver 1.0

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Specialised Financial Instruments and their Valuation

Specialised Financial Instruments and their Valuation

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  • 1. Author: Partho Chakraborty SLS Backed MTNIntroductionAny Financial Instrument draws its intrinsic value through collaterals. Collaterals areassets provided to secure an obligation. Traditionally, banks might require corporateborrowers to commit company assets as security for loans. Today, this practice iscalled secured lending or asset-based lending. Collateral can take many forms:property, inventory, equipment, receivables, oil reserves, etc. Collaterals give theinstrument not only their value but also ensure that the financial instrument getstraded and acts as security whereby a line of credit can be drawn against it.Collaterals can be of any form as long as it gives a value to the Financial Instrument.The most favoured collateral is cash and thus any cash backed financial instrumentis most favoured and always in demand. But on the other hand given a choicenobody wants to block cash given its liquidity. Thus the majority of FinancialInstruments have little or no cash. It will have movable or immovable assets, assetssuch as shares, debentures, etc.SLSThe latest entrant as a collateral is SLS. SLS stands for Senior Life SettlementPolicies. A senior life settlement involves the sale of an unwanted insurance policyto a third person at a price that is lower than the policys face value. The originalpolicy owner gets a lump sum in cash. The third party is then legally responsible forall further premiums on the policy. This settlement amount, as a rule, exceeds thepolicys cash value accumulated until that date.Senior citizens often opt for senior life settlements for a variety of reasons. This ismostly done when the person encounters an emergency or other financial need. Thesenior life settlement company buys the policy from him and collects his premiums inan escrow account. When the policy is bought by a third party, the original holdercan stop paying the premium. Then the new buyer takes over, after paying the cashfor the policy.Generally, people take several policies in their early life. But, when they enter intoold age, people find that they no longer have to keep many of those policies. Also,many senior citizens find it difficult to pay insurance premiums. In order to alleviatethe financial strain of paying the premiums, many seniors choose to take a policysettlement.There are many settlement brokers who make the entire process of life settlementpolicy easier. They first analyze the policies and auction them to various interestedparties. The policies are sold to the person or people who offer the highest bid. Thenew holders are then liable for all the premiums on the policy going forward. Seniorlife settlement policies can be owned and bought by individuals or companies.SLS Policies have varying terms and varied redemption amount. These policies mustbe synchronised to the MTN’s tenure. For example, if a MTN is for a 10 year period,the SLS policy must be less than or equal to a 10 year maturity such that it maturesbefore the MTN’s maturity date. 1
  • 2. Author: Partho ChakrabortyFor example a MTN for say US$ 100 face value maturing in say September 25,2011, could have SLS policies for amounts such as US$ 10 maturing in August 21,2008, US$ 50 maturing in September 25, 2010 and say US$ 40 maturing inSeptember 01, 2012. The maturity dates of SLS policies could be more or less closeto the maturity date of the MTN but it can never exceed the maturity date of theMTN.The SLS Policies once redeemed pays for the MTNs face value. SLS Policies in thesecondary market has seen a huge growth with various reports suggesting that itcould touch US$ 200 Billion in years to come.MTNMTNs or Medium-term Notes are corporate debt obligations offered to investorscontinually over a period of time by an agent of the issuer. They are offered to thepublic under SEC Rule 415 (the self registration rule). This rule allows issuers tosell securities on a continuous basis so that issuers have the flexibility to issuesecurities in favourable market conditions. They are priced at a spread to theTreasury yield curve at the time of the offering and typically issued at par. Thematurities vary from 9 months to 30 years. Note that the term "medium-term notes" isnot related to the term to maturity of the securities and Borrowers can issue fixed- orfloating-rate MTNs.A medium term note (MTN) is a debt note that usually matures (is paid back) in 5–10 years, but the term may be less than one year or as long as 50 years. They canbe issued on a fixed or floating coupon basis. Floating rate medium term notes canbe as simple as paying the holder a coupon linked to Euribor +/- basis points or canbe more complex structured notes linked, for example, to swap rates, treasuries,indices, etc. When they are issued to investors outside the USA, they are called"Euro Medium Term Notes". Issuance of MTNs to investors based in the USArequires a separate US MTN program.MTNs can be issued with a fixed maturity date (non-callable) or can be issued withembedded call or put options and triggers where the notes will redeem early basedon certain parameters. MTNs are most commonly issued as senior, unsecured debtof investment grade credit rated entities which have fixed rates. MTNs offer moreflexibility to the issuer and investor both in terms of structure and documentation.The Walt Disney Company issued a note with a term of 100 years! So notes is amisnomer, but it did describe them more accurately when General MotorsAcceptance Corporation (GMAC) first issued them in the 1970s as notes with termsgreater than commercial paper, but less than most bonds, so that GMAC couldmatch the terms of the notes with its auto loans.This type of debt program is used by a company so it can have constant cash flowscoming in from its debt issuance; it allows a company to tailor its debt issuance tomeet its financing needs. The main benefit of MTNs over bonds to both issuers andinvestors is the flexibility of its structure and documentation. MTNs can match MTNterms with liabilities of the issuer.MTNs can have floating or fixed rates; formulas that tie return to equity, commodity,or currency prices. They can even have calls, puts, other options built into them. 2
  • 3. Author: Partho ChakrabortyThey can be issued as zero coupons, or have step-up or step-down coupons, orinverse floating rates; or be denominated in a foreign currency, or pay interest basedon an index. Interest payments can be monthly, quarterly, or semi-annually.ValuationAs mentioned-above MTNs are merely pieces of paper deriving their underlyingvalue through cash or assets or SLS. If a MTN is issued by the Government then it isbacked by a Sovereign Security. In theory any corporate can issue a MTN and giveits value through any asset such as SLS. Thus the value of a SLS based MTN isactually the value of the SLS and the coupon or interest it pays. The SLSs would beredeemed on maturity giving the face value of the MTN to the holder of theinstrument. It also would have to generate the interest to be paid to the holder on aper annum basis till maturityA MTN has a fixed tenor and gives a fixed return. So the SLS must be factored togive the desired return at the maturity date. As MTNs are generally of high values,they would require many SLS to give it its value.A policy is normally valued by first finding out its Paid-up value, then deriving theSurrender value and finally the Loan value. In these Structured Products theSurrender Value is typically less than 1% of Face value. So a US$ 5 Million Policywill have less than US$ 50,000 as Cash Surrender Value (CSV). The reason theCash Surrender Value is so low is to discourage encashment of SLS as thepremiums paid is used to service the Coupon and at the same time build up thereserves to pay the Face Value of MTN on Maturity. Care is also taken to minimisethe premiums to the lowest possible level, which leaves hardly any room for CashSurrender Value.Also the structure is such that the Cash Surrender value is separate from the NetPresent Value (NPV), as the NPV is based upon the rate of return of the policy,(typically NPV is based on 21.00 % IRR) based on when the policy matures.......thatis the core of SLS business. As mentioned before, by design there will typically bevery little CSV as the investor goal is to limit the premium payment only to "cost ofinsurance" ("COI" ...the lowest premium possible and still keep the policy in "goodstanding") thus no build up of CSV. The reason for COI premium v/s a higherpremium building CSV is that the investor return on cash invested needs to be in the15 – 21% IRR range and the insurance carrier is only going to credit 3.5 – 6.5% onthe premium in excess of COI. Accordingly, the MTN would pay only the COIpremium and any CSV will be extremely nominal.Suppose you are purchasing $550M for the $200M MTN (2.75 to 1), the market costof SLS acquisition would be between US$49,500,000 to US$ 60,500,000; the Cashreserves held within the Trustee would be $90,500,000 to $110,500,000.This gives US$ 140 Million to US$ 171 Million or 70% to 85.5% of the MTN facevalue.The cash surrender value would be on average 1% per policy, which would be US $5,500,000 3
  • 4. Author: Partho ChakrabortyLet us calculate the valuation for a US$ 200 MTN with a Coupon of 6.5% per annumfor 8 years.Let us find out the Present Value of the par value or face value. For this we use theFormula to find the Present Time Value of Money:Where the values are:A = US$ 200r = 6.5%n = 8 yearsP = 120.85Let us now find out the Present Value of the Coupons. For this we use the formula tofind out the Present Value of Coupon PaymentsWhere the values are:c = 6.5r = 6.5%n = 8 yearsC = 39.58Adding both the present values we get: US$ 160.43US$ 160.43 is 80.21% of MTN face value. This is consistent with the value of SLS asshown above in Page 3.If we take 80% of 160.43% as computed above, the loan amount for a MTN of US$200 is US$ 128.34. 4
  • 5. Author: Partho ChakrabortyNote: Names are Suggestive and are strictly not to be taken on Face Value. It is only to give a feel and touch of how transactions can be structured and names are indicative This article is meant for education purposes only and it is not be reproduced for any commercial purpose by print or electronic medium whatsoeverThis article is written by:Partho H. ChakrabortyA - 305, DSR Spring Beauty Apts., 124/1, ITPL Main Road, Brookefields, Kundalahalli, Bangalore -560 037, IndiaTel: +91 80 420 50293, Cell: +91 99863 22504email: parthohc@airtelmail.in; parthohc@rediffmail.comSkype: parthohc01 5