Bank A has been given the opportunity to buy a large number of US dollar-denominated bonds issued by Energy Enterprises (EE), a triple-B rated British utility company. This would amount to a principal amount of $100 million—but the bonds are currently trading in the market at a discount.
The bonds carry a fixed annual-pay coupon of 6 per cent and have exactly five years to maturity—so the first coupon you will receive from buying the bonds is one year away. There is no accrued interest.
The bonds are being offered to Bank A at 84.837 per cent of par. At this price, the yield-to-maturity on the bonds is 10 per cent.
Unfortunately, Bank A, although interested in the opportunity, would want to hold a floating rate asset, not a fixed-coupon bond.
However, the Investment Bank (IB) has offered to repackage the bonds for Bank A as synthetic floating rate notes via a special purpose vehicle.
The deal is as follows: Bank A will provide $100 for each bond purchased and will receive LIBOR, as the floating rate, plus a 20 basis points spread (0.20 per cent) over the reference rate for the five years, plus a repayment of the $100 principal at maturity. These floating rate payments will take place at the end of each year (i.e. annually) to match the payments on the bond and up to and including the final maturity at the end of year 5.
The terms and conditions in the US dollar interest-rate swaps market are given below:
Par swaps rate against LIBOR
1 Year 9.50%
2 years 9.59%
3 Years 9.62%
4 Years 9.69%
5 Years 9.70%
Why would Bank A rather hold a floating rate asset issued by EE rather than the fixed rate bonds.