Synthetic assets: asset swap types

The types of asset swap transac­tion are dictated by the investor base for such syn­thetic assets. This, in turn, is driven by the objectives that drive investment in asset swaps. The main factors include:

  • The increasing securitisation of capital markets that has led borrowers to issue securities to raise money. This is driven by the fact that capital markets provide funding on more competitive terms than that available from financial intermediaries, primarily banks. This is particularly the case with borrowers of high credit quality (investment grade, particularly A or better). In the US and to a lesser extent in Europe, the trend to securitisation has extended to non-investment grade borrowers, driven by the rapid growth of high yield debt markets in the US and Europe. This development has created shortages of conventional loan assets, particularly by better credit quality borrowers. As a result, many banks face the lower growth of the asset base, as these entities lose their historic corporate customer base to the securities markets
  • The (often substantial) improvement in return that is achievable through synthetic assets relative to the purchase of direct investments. Under certain market conditions, there are opportunities for a yield pick-up through asset swaps. This creates a ready-made market for these synthetic assets, primarily among banks
  • Use of asset swaps also helps banks to increase the level of diversification of their asset portfolios. This has the effect of reducing the risk of the portfolio.
  • Similar factors have attracted tradi­tional investors (such as insurance companies, pension funds and investment managers) to the asset swap market.

The major types of asset swaps include:

  • Assets denominated in any currency swapped into synthetic dollar Libor based forward rate notes (FRNs) for placement primarily to banks. This is extended to asset swaps designed to create synthetic FRNs in currencies other than $ to match demand for non-$ floating rate assets from banks
  • Asset swaps that entail the creation of synthetic fixed rate bonds (in currencies such as $, euro and yen) utilising either fixed or floating rate securities in a variety of currencies for sale to institutional investors.

Asset swaps involving the creation of synthetic $ Libor based FRNs placed with banks constitute the most significant sector of the asset swap market. The pre­dominance of this structure primarily reflects the nature of the underlying investment demand. This demand is from commercial banks seeking floating rate assets (loan type assets) that can be match funded. The continued need for high quality and relatively high yield assets by a large group of commercial banks seeking asset growth drives this particular market segment. The major source of demand for this type of asset swap is medium to smaller banks. These banks are driven by the absence of direct access to the under­lying credit assets, the need for portfolio diversification and the inability to finance foreign currency assets. The yield pick-up often available from asset swaps compared with the return available on equivalent direct investments provides an additional incentive for these banks.

The attraction of synthetic $ FRNs created utilising asset swaps also relates to the call features on normal FRNs. The call option on an FRN allows the borrower to redeem the issue prior to maturity. In the late 1980s/early 1990s, the absence of high quality assets and competition among financial intermediaries led to decreasing levels of call protection on FRN issues. FRNs with protection against calls tend to trade at a premium to par causing a significant erosion in margin that is unattractive to investors. Asset swaps are particularly attractive for these investors, as the under­lying asset will have, in most cases, higher levels of call protection. A similar argu­ment is relevant for banks. This is because most bank loans are callable/pre-payable at short notice. The asset swap, in contrast, provides significant call/pre-payment protection.

Securities

The construction of the asset swap requires trading in the underlying debt security and entry into a swap transaction. The availability of the underlying debt securities is essential to the asset swap process. The existence of a discrepancy in the relationship between the yield on the assets and swap rates is also desirable. These discrepancies provide the basis of the arbitrage/ higher returns available on asset swap transactions.

The discrepancies in market values arise from the differential pricing of assets in different segments of financial markets. This reflects different credit criteria or restrictions on asset choice. These create supply and demand imbalances that lead to asset pricing anomalies that provide opportunities for arbitrage.

Discrepancies in the relationship between asset returns and swap rates are more complex. Opportunities for arbi­trage emerge when asset yields move to a level that allows the securities to be swapped. The objective is based on the prevailing structure of swap rates to gen­erate a coupon stream in excess of that on equivalent direct investment. Effectively, the process is one of transferring the par­ticular security from one market segment to another to equalise supply and demand at a given price.

The types of securities used in asset swaps include:

  • Bonds available in the secondary market
  • Structured debt issues such as equity-linked securities (ex-warrant debt component of a bond with equity war­rants issue or convertibles) and mortgage/asset backed securities. Other types of structured securities utilised in asset swaps have included perpetual FRNs and tax advantaged securities
  • New issues specifically designed to be asset swapped.

A major source of securities for asset swaps has been older (seasoned) bonds available in the secondary market. These bonds are often relatively illiquid and/or mis-priced and they frequently provide attractive opportunities for asset swap transactions. The use of these bonds in asset swaps is driven by the trading pattern of non-government debt securities.

The behaviour of a liquid high credit quality bond issue tends to follow a spe­cific trading pattern. During the term of the bond, the trading history of the security in spread (to a government or swap benchmark rate) generally approx­imates the following behaviour. The spread is credit related. This means that it should be greatest at the issue date and decline over the life of the transaction to almost zero close to maturity when the credit risk is negligible. This assumes that the credit quality of the issuer remains unaltered and that the issue is successfully priced and placed. It also assumes that the bond is liquid, that the credit quality of the issuer is high/con­sistent and that there is the presence of a substantial number of major market makers willing to make consistent two-way prices in the issue throughout its life. These conditions are only satisfied infrequently. The issues that generally satisfy these conditions are large “bellwether” or benchmark issues under­taken by large frequent issuers of reasonable credit quality (generally investment grade).

Most bonds typically behave more erratically and, even if launched at the same spread relative to the benchmark as a liquid benchmark issue, will tend to trade at wider spreads over time. This reflects the lack of liquidity in the issue and is a function of a number of factors including the lower size of the issue, the (sometimes) lower credit quality of the issuer and the lack of market makers in the particular issue. It also reflects a lack of trading interest among investors in these issues.

As the spread of these issues increases relative to more liquid and better traded issues, the higher yield on these bonds facilitates asset swap arbitrage. This arbi­trage is facilitated by the fact that the investors in floating rate assets will tradi­tionally be commercial banks or other financial intermediaries. These institu­tions match fund their assets usually through the short-term money market at a cost relative to Libor or equivalent benchmark. These institutions are seek­ing good quality assets equivalent to traditional loans that are likely to be held to maturity. These investors will be less concerned about the factors that are dri­ving the bond’s poor performance in the secondary market.

Specific events also facilitate asset swap transactions. These include:

  • Changes in credit quality may precip­itate sudden changes in values of bonds. The relevant change may affect the market generally, a country (or group of countries), an industry or a specific issuer
  • General market shifts such as a ‘flight to quality’ during periods of market uncer­tainty and dislocation. These changes frequently lead to disinvestment from spe­cific sectors of the market. Investor focus is on reducing exposure to riskier, less liquid securities and increasing exposure to high credit quality, liquid securities. It might also entail changes in investor preference for maturity with an increased demand for short dated securities
  • Mis-priced bonds that proves difficult to place resulting in poor trading perfor­mance. Mis-pricing can occur for a variety of reasons. Mis-pricing may be the result of unanticipated changes in market conditions. It may also result from errors in the judgement of underwriters. A frequent source of mis-pricing is an issue being priced to accommodate the new issue swap arbitrage on the liability side for the issuer.

The special events all tend to lead to rapid changes in market values as trading activity is focused on adjusting portfolio positions rapidly. This frequently leads to the market over-shooting in a particular direction generally or individual issues being mis-priced (as they trade indiscrim­inately with the market/sector at large). This creates opportunities for asset swap transactions.

Structured debt securities frequently provide opportunities for asset swap trans­actions. These include equity-linked securities, mortgage/asset backed securities and a variety of structured issues.

A large source of securities for asset swap transactions has been the ex-warrant debt component of a debt with equity warrants issue package. Historically, the major source has been Japanese corpora­tions. In many cases, a bank guarantee or letter of credit securing the debt compo­nent of the issue enhanced the Japanese issuer’s credit. However, the practice is more general and not confined to Japanese issuers.

The primary attraction of the equity-linked issues are the equity warrants. These are stripped off and sold separately from the underlying debt component. The debt component itself usually has a below market coupon because of the economic value of the equity warrants. Consequently, the debt component trades at substantial discount to its face value shortly after issue once the warrants had been stripped off and sold. The ex-warrant bond usually trades at a higher yield relative to comparable securities.

This primarily reflects its illiquidity and deep discount structure.

The use of ex-warrant bonds in asset swaps was a major feature of the markets in the late 1980s and early 1990s. More recently, asset swaps involving convert­ible bonds have emerged as a major part of the market for asset swaps.

An important source of securities for asset swapping are collateralised mortgage obligations (CMO) (effectively mortgage backed securities (MBS)) and asset backed securities (ABS). MBS and ABS typically offer higher yields than compa­rable corporate or financial institution paper. This added return is partially in return for the investor in the securities accepting the risk of prepayment. If interest rates fall, the underlying mort­gages or assets tend to be prepaid, effectively resulting in the MBS itself being called. However, this risk of pre­payment does not preclude the use of CMO/ABS for asset swaps.

The market has evolved a number of approaches to dealing with the prepay­ment risk on the asset underlying the asset swap package. They include:

  • Amortising swap — the basic approach uses an amortising swap struc­ture. In typical asset swap structures involving CMO/ABS, the investor would purchase the security and enter into an amortising swap. The investor receives the coupon on the security. The coupon is based on the actual remaining balance of the asset (eg mortgage) pool. The investor pays a fixed rate and receives a floating rate plus a margin on an amortising interest rate swap. The amortising interest rate swap is structured so that the notional principal reduces. The rate of reduction is based on the expected rate of amortisation of the underlying asset. The investor is exposed under this structure to prepayment risk. Any deviations in prepayments from the assumed amortisation will result in a mis­match between the CMO/ABS host debt and the payments under the swap
  • Option on swaps — this combines the amortising swap with option on swaps to minimise the underlying pre­payment risk. This approach uses putable swaps (a combination of a swap and a receiver option on swaps) to convert the CMO/ABS security to a floating rate asset. As interest rates decrease, the putable swap terminates. This is designed to match the prepayment on the underly­ing securities. The structure of the swap provides some pro­tection against prepayment on the CMO/ABS. However, the protection is imperfect. This is because, as interest rates decline, the prepayment on the CMO/ABS may be faster/slower than the pre-agreed termination schedule on the putable swap

  • Index amortising swap — as swap technology has improved, specially struc­tured CMO swap arrangements have developed. This involved the use of index amortisation swaps (IAS) to swap CMO/ABS debt. Under these structures, the investor swaps the CMO issue into floating rate return with lower prepay­ment risk. The swap counterparty, in return for paying a lower floating rate return to the investor, absorbs some or all of the duration risk of the transaction. If interest rates fall, the duration of the swap will correspondingly decline as mort­gagors accelerate their principal
    repayment in order to refinance at lower interest rates. These structures generally amortise based on movements in a nom­inated interest rate (such as constant maturity Treasury rates) that is expected to be closely related to the rates that drive prepayment on CMO/ABS debt. This is assumed to enable the investor to closely match the weighted average life sensitiv­ity of the CMO/ABS to the interest rate swap. This approach, while more com­plex than the amortising swap and option on swaps, is expected to provide a more accurate amortisation match. However, the actual performance of the IAS will depend on the degree to which the design of the swap will be able to repli­cate the prepayment pattern of the CMO/ABS.

Asset-backed securities (particularly short-term credit card and auto receiv­ables) utilised in asset swaps have produced different problems. Shorter-term receivables demonstrate a more volatile and random repayment pattern. This means that the swaps designed to convert income streams from these secu­rities into floating rates for investors need to be structured on the basis of an assumed repayment schedule for the underlying debt. As actual repayments occur, the swap counterparty is forced to assume the residual position generated by variations from the assumed repayment schedule. In the event that interest rates decrease and prepayments are higher than anticipated in the repayment schedule, the swap counterparty may end up with an out-Of-the-money swap as the swap related to the asset backed issue is extinguished before its scheduled maturity. Swap market-makers can utilise options on swaps to neutralise this risk of prepayment at a cost.

Structured and hybrid securities also provide frequent opportunities for asset swap transactions. Most structured prod­ucts are created as a result of demand from investors. Where the investor wishes to trade the structured note, it is usually not feasible to on-sell the structured note in the original form. This means that the notes must be “reverse engineered” to be placed with new investors. This is usually struc­tured as an asset swap whereby the original note is repackaged by combining it with a derivative(s) transaction(s) to eliminate the embedded derivative features of the note. The re-structured note (which is usually a fixed or floating interest rate note) is sold as an asset swap to traditional investors. A central feature of the repackaging of these complex security structures is that it is typ­ically an attractive way to generate liquidity for the holder. The re-engineered security will generally have broader appeal to investors facilitating disposal of the asset by the original investor.

A separate category of securities used in asset swaps are new securities issues specifically designed to be sold in a syn­thetic/asset swap format. These issues are usually for lower credit rated issuers. They are designed to allow access to the fixed rate bond market from which they would be otherwise precluded. The fixed rate bond is sold in synthetic form as a $ Libor FRN, primarily to bank investors. This practice is used mainly in markets where there is limited demand for low credit quality issuers.

Securitised asset swaps

Until September 1985, asset swaps had been traditionally undertaken as private transactions structured primarily as private transactions or synthetic securi­ties. In September 1985, the concept of the public or securitised asset swap was introduced with two transactions. Hill Samuel led the first transaction. Merrill Lynch Capital Markets arranged the other transaction. An analysis of the Merrill Lynch transaction provides an insight into the mechanics of the securi­tised asset swap.

The end result of the repackaging was the creation of a conventional fixed interest security for the investor. The securitised asset swap structure helped the investor avoid any need to either purchase the underlying securities or enter into the swap transaction. The structure met investor requirements in terms of

  • Credit quality
  • Interest rate and currency requirements
  • Capacity to have the security listed, rated, cleared and settled through existing clearing systems
  • Liquidity and ability to be traded.

The structure also subtly changes the risks of the asset swap structure. The dealer has no credit exposure to the investor because the swap is secured over the collateral held by the special purpose vehicle. In contrast, the investor contin­ues to be exposed to the credit risk of both the collateral and the derivative dealer.

The basic structure described contin­ues to be the basis of the design of all repackaging vehicles.

New dimension

For financial institutions active in swap trading/market making, asset swaps pro­vide a new dimension in their activities. At the most basic level, asset swap activ­ity creates additional transaction volume that increases the underlying liquidity of the relevant swap market. It provides the other side to the liability swap arbitrage. It thereby creates an incentive for swap activity during periods when the liability swap arbitrage window is not operating. This additional liquidity improves the pricing performance and efficiency of the relevant swap market.

In essence, the asset and the liability swap are the opposite ends of the same transaction. This is because many new issues are undertaken on a fixed rate basis with an accompanying swap whereby the issuer receives the fixed rate to service the issue and pays floating rates. The pattern of payment under the liability swap in the new issue arbitrage is exactly the opposite side of the swap needed to generate syn­thetic assets. In an asset swap, the purchaser of the asset generally will need to pay a fixed rate in return for receiving a floating rate of return. Essentially, the presence of the asset swap enables finan­cial institutions active in swap trading/market making to operate more or less continuously in the expectations of liquidity generated from both ends of the arbitrage.

For swap counterparties, the evolu­tion of the form of the asset swap is also significant. Of particular significance, is the development of the public or securi­tised asset swap structure. The major advantage to swap counterparties is the changing credit risk implications of this particular structure. From the swap dealer’s perspective, the public or securi­tised structure, through a special purpose vehicle, significantly reduces its exposure to the investor because the issue vehicle is collateralised by the bonds being repackaged. The dealer has first call on that collateral allowing swap counterpar­ties to enter into asset swaps with investors that the dealer would not be able to deal with directly. In essence, under the public or securitised asset swap structure the investor takes a risk on the dealer but the dealer removes exposure to the investor. This absence of credit risk improves the pricing efficiency of the swap market.

 Norman Sachs

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