Weird bonds

https://www.waminvest.com/files/SP091411.pdf

Look at the very last entry on Page 10.

I suppose bonds like this have been around for a long time, but I’ve never been asked to analyze one. It looks like it pays a flat 10% coupon for five years. After that, it pays the difference between the 30-year CMS rate and the two-year CMS rate, multiplied by a multiplier. (Starts at 5x, then moves to 7x, then 10x. (Coupon is capped at 10%)

So, if I’m right, if the two year rate is 3% and the 30-year rate is 5%, then it will pay 7 x 2%, or 14%, or 10%, whichever is less.

This begs two questions - 1.) What is the Constant Maturity Swap rate? Where can I find the rate curve? What might cause the spread to narrow? and 2.) Why would anybody issue this kind of bond?

Ah yes, this is a somewhat popular rates/equity hybrid structured note called “contingent range accruing” notes or something like that, depending on the issuer.

“So, if I’m right, if the two year rate is 3% and the 30-year rate is 5%, then it will pay 7 x 2%, or 14%, or 10%, whichever is less.”

Correct.

“1.) What is the Constant Maturity Swap rate? Where can I find the rate curve? What might cause the spread to narrow?”

CMS is pretty simple to understand. For example, the 30y CMS rate is the 30y rate, from the observation date. So if today is 8/22/2017, the 30y CMS rate is the swap rate for 8/22/2047. Tomorrow, the 30y CMS rate will be the rate for 8/23/2047. This is counter to conventional rates/swaps pricing, which is based on fixed dates, not fixed terms from the observation date. For instance, under conventional (non constant maturity) rates trades, you will get payments based on LIBOR or another rate on a fixed date, say 8/22/2018, while the constant maturity rate rolls forward based on what day it is today.

You can derive the CMS from the normal yield curve. For instance, if you want to know the market estimate of the 30y CMS rate 1y from today, you would find the 1y/31y forward rate from the yield curve - basic CFA material.

In this case, the spread narrowing means the yield curve will have become less steep. This can happen due to a variety of macroeconomic effects.

“2.) Why would anybody issue this kind of bond?”

The same reason they would issue any kind of bond - to charge a spread. The seller of this bond can hedge all market risks. For instance, the issuer is short some kind of call option on SPX, since the coupons are paid only if SPX is “850 up” in 5 years. So, if the issuer can buy this option in the market for a lower implied volatility, they can hedge their exposure while collecting a spread. Similarly, the issuer is long interest rate volatility, short interest rate term structure, and short rates/equity implied correlation. So, their goal is to hedge these risks at levels better than those offered in the structured note.

“You can derive the CMS from the normal yield curve.” From what curve? The treasury yield curve? Does the CMS generally mirror treasury rates, or do swaps have their own curve that doesn’t resemble treasuries?

Most interest rate products, including this one presumably, benchmark the LIBOR/swap curve, not the treasury yield curve. LIBOR is quoted up to 12 months by contributors. The swap curve after that is the market expectation/extrapolation of future LIBOR rates.

Watch out for opaque fees on products like this.

^For example?

I assume that the only place that Morgan Stanley can charge a fee would be on the bond coupon. So if the bond coupon lines up with the offering (to the extent that I can determine what the coupon should be), then where else could a fee come from?

I’m not familiar with these products - at all - but with DOL still hanging out there, I’d stay away from any product you can’t explain to a five year old (that’s about the average intelligence of an SEC auditor).

Fee reporting requirements are pretty strict for products like this nowadays. The offering document should disclose the total commissions and embedded costs.

Anyway, the thing about long dated derivatives like this 20y product is that market structure tends to be distorted due to supply/demand imbalance at long maturities. For instance, we would not actually expect long dated rates to be perpetually upwards sloping, nor should we really expect implied volatility or implied correlation to follow the same behavior over time. So, there is a high likelihood that the long term behavior that you lock in by trading a long dated product will not be the same as what will actually be realized. Whether this is good or bad depends on which side of the market structure you are on.

The other thing is that these severe market structure distortions, and the inaccessibly to normal investors, means that their materiality to the product might be much more than fees or expenses. Sure, JPM might mark this product to some long dated market data, but you don’t care what that is, if the whole market structure does not make sense and you cannot trade it anyway.

We didn’t recommend this. A client is holding this (and several more like it) in a self-directed 401k plan outside of our firm. The boss asked me to figure out what his holdings were and get back to him.

I agree with your take on things. I am by no means the smartest guy in the room. But if I can’t understand it, then I don’t recommend it.

(I’m having the same trouble with the mutual fund DSENX. I can’t figure out how the derivatives work. But I can at least understand the theory on that one.)