09/01/01goldman sachs: debt issuance copyright (c) 1998-99, marshall, tucker & associates, llc....

09/01/01 Goldman Sachs: Debt Issuance Copyright (c) 1998-99, Marshall, Tucker & Associates, LLC. All rights reserved

1

Offshore Markets:

Offshore issuance: Securities sold outside the United States to non-U.S. investors do not have to be registered with the SEC. The largest of the offshore markets is the Eurobond market.

Seasoning: Once securities have been issued outside the United Stated and have traded for at least 90 days, they can be purchased by U.S. investors. After 90 days of trading, the securities are said to be seasoned.

International Syndicates: Assembled to sell U.S. securities outside the United States.

Dual Syndications: Includes both a domestic syndicate for selling within the U.S. and an international syndicate for selling outside the U.S.

Debt Issuance


2

Issuance through Private Placements:

Private placements involve the sale of securities directly to a group of qualified investors (as defined in rule 144A). These investors include mutual funds, insurance companies, hedge funds, and pension funds.

Over the years, the number of institutional investors has grown very rapidly. Today, institutional investors hold the overwhelming bulk of common stock and most bonds, on behalf of the beneficial owners, which remain, for the most part, small investors.

Private placements most often involve debt issuances and preferred stock issuances, as opposed to common stock issuances.

Note: Rule 144A does not permit U.S. corporations to sell common stock through a private placement but it does permit foreign corporations to sell common stock in the United States through a private placement.

Debt Issuance


3

Benefits of Private Placements for the Issuer:

Sales of securities to qualified investors are exempt from registration with the SEC under rule 144A. This reduces both the cost of preparing the issuance and increases the speed with which the issuance can be made.

Securities are sold to a smaller number of investors, which reduces various administrative costs (e.g., annual report mailings, registrar costs, paying agent costs, etc.)

The securities can be structured to suit the needs of the issuer and the needs of the investors in ways that would not be possible if the securities are issued through a public offering.

Securities can be sold that do not have a top-rating or which do not have any rating at all.

Debt Issuance


4

Benefits to the Investor:

Because the issuer saves considerably from not having the incidental expenses associated with a public offering, the issuer can pay a higher coupon than it would have paid on a public offering and still come out with lower cost.

The investor can obtain a structure with investment characteristics that it could not have obtained in the public offering market.

Debt Issuance


5

Example:

Suppose that a corporation can do a public offering of a ten-year debt security and sell the security at par if it pays a coupon of 8.00%. However, the flotation costs (including underwriting fees, accounting fees, legal fees, filing fees, rating agency fees, etc.) and the ongoing administrative costs amount to an additional annualized cost to 1.75%. Thus, the all-in cost of the issuance is 9.75%.

If the corporation does a private placement of the securities, the lower flotation costs and lower administrative costs work out to an annualized cost of 0.75% a year. The corporation agrees to pay a coupon on the private placement of 8.50%. This is .50% more than it would pay on a public offering, but the final all-in cost is only 9.25%.

Conclusion: The issuer saves 0.50% a year and the investor earns 0.50% a year more.

Debt Issuance


6

Structuring Securities in Private Placements:

Privately placed securities are often highly structured, meaning that they have been “engineered” from component parts in order to satisfy the needs of both the issuer and the investor. The needs of these two parties can be very different.

The component parts of the structuring process often include over the counter (OTC) derivatives. When structuring will involve OTC derivatives, then the private placement desk will work closely with the Derivative Products Group (DPG).

Derivative products include forwards, swaps, and a variety of options.

Debt Issuance


7

Debt Issuance

What is a swap?

A swap is a bilateral agreement in which two parties, called counterparties, agree to exchange a series of payments over time.

Swaps range from very simple structures, called plain vanilla, to very complex structures, called exotics.

counterparty 1 counterparty 2

payment

payment


8

Debt Issuance

What are the main categories of swaps?

Currency swaps (introduced in London in 1979)

Interest rate swaps (introduced in London in 1981)


9

Debt Issuance

What are plain vanilla interest rate swaps?

A plain vanilla interest rate swap is a bilateral agreement between two parties in which one party agrees to pay a fixed rate of interest to the second and the second agrees to pay a floating rate of interest to the first. These payments are made at regular intervals (usually semiannually) for a specified number of years.

By fixed rate of interest we mean an interest rate that is set at the time the swap is negotiated and which does not change over the life of the swap. This fixed rate of interest is called the swap rate.

By floating rate of interest we mean that we periodically observe some benchmark rate. We observe the benchmark rate at the beginning of a coupon period and then pay it at the end.


10

Debt Issuance

Common benchmarks for the floating rate:LIBOR (6-month LIBOR, 3-month LIBOR, 1-month LIBOR)

T-bill

prime

repo

CP

CD

time

write swap

payobserve LIBOR

first payment

repeat repeat


11

Debt Issuance

Indicative Pricing Schedule

Tenor GS pay rate GS receive rate T-Note Rate 1 TN + 40 bps TN + 44 bps 5.20% 2 TN + 44 bps TN + 48 bps 5.38% 3 TN + 46 bps TN + 51 bps 5.50% 4 TN + 52 bps TN + 58 bps 5.60% 5 TN + 58 bps TN + 64 bps 5.68% 7 TN + 62 bps TN + 69 bps 5.82%

Counterparty 1Counterparty 2

Goldman Sachs

How does Goldman Sachs make money from its role as a swap dealer?

USD notionalsreceive rate

LIBORUSD notionals

Counterparty 3

USD notionalspay rate

LIBORUSD notionals


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Debt Issuance

• In a currency swap, the two legs are fixed and there are two principals, each denominated in a different currency. The principals may be notional only, or they may be real. When real, the principals are exchanged at the inception of the swap at then re-exchanged at swap maturity. Real principal currency swaps tend to accompany new issues, whereas notional principal currency swaps tend to relate to outstanding issues. Example: 5-year Yen-dollar real principal swap with annual periodicity, $10 million 6% p.a. and Y1.1 billion:

$10 million (at time 0)

Y1.1 billion (at time 0)

6% p.a. ($) (annual for five years)

3% p.a. (Y) (annual for five years)

$10 million (at the end of 5 years)

Y1.1 billion (at the end of 5 years)

GoldmanSachsSwapDesk

SwapCounter party


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Debt Issuance

• With a cross-currency interest rate swap, one swap leg is fixed and denominated in one currency while the other swap leg is floating and denominated in a second currency. Thus a cross-currency interest rate swap is simply a combination of an interest rate swap and a currency swap. For example, the swap dealer pays s.a. $LIBOR on $10 million for 3 years, and the counter party pay 3% on Y1.1 billion for three years where both principals are notional.


14

Building Structured Securities:

Consider the following scenario. A corporation decides that it needs to issue $1 billion of four-year fixed-rate debt. It would like to do it through a private placement.

The private placement desk discusses the matter with institutional sales and trading. They identify three investors who would be willing to hold the corporation’s debt. One investor is willing to hold $500 million of fixed-rate debt and another is willing to hold $300 million of fixed-rate debt. The fixed rate debt would pay a coupon of 9.00%. The third is willing to take $200 million, but requires floating-rate debt in the form of a floating rate note that pays LIBOR + 100 bps.

Debt Issuance


15

Corp. Issuer

Debt Issuance

Investor 1

9.00%

9.00%

$500 mm

Corp. Issuer

Investor 2

9.00%

9.00%

$300 mm

Corp. Issuer

Investor 3

fixed

floating

$200 mm

?


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Debt Issuance

Corp. Issuer

Investor 3

fixed

floating

$200 mm

?

Corp. Issuer

Investor 3

8.75%

LIBOR +100 bps

$200 mm

Goldman Sachs

DPG

Note

7.75%

LIBOR


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Corporation

Debt Issuance

GS CorporateFinance

ECGSDCGS

Private Placements

GS DPG

Syndicate

Inst. S&TPCS

Inst. S&T

Inst/RetailInvestors

Inst/RetailInvestors

Institutional Investors

Summary of Corporate Finance and its Relationships to Other Areas of the Firm

Public Offerings

Private Placements


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Debt Issuance

Case Study I: Goldman Sachs-Skopbank

• December 1989

• Japanese life insurance companies seeking enhanced interest income

• Skopbank AAA rated

• Skopbank traditional funding in US dollars and at $LIBOR flat

• Nikkei 225 at about 38,200

• Seasoned 1-year AAA-rated Euro-Yen bonds yielding 6.10%

• Yen-dollar rate at about Y144/US$1

• Annualized vol of Nikkei about 13% (in Yen)


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Debt Issuance

• Terms of Issuance:

Issuer: Skopbank

Size: Y6.7 billion

Coupon: 7%

Maturity: 1 Year

Issue Price: 101-1/8

Call Options: None

Denomination: Y100 million

Commissions: 1-1/8

Redemption: If at maturity, Nikkei > 31,870.04, then redemption at par. If Nikkei <

23,902.53, then redemption is zero. If in between, then redemption is

Y100 million x {1 - [(4)(31,870.04 - Nikkei)/(31,870.04)]}


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Debt Issuance

• Skopbank issues a plain-vanilla 1-year, fixed-rate Euro-Yen bond and buys an embedded, European-style, out-of-the-money capped put on the Nikkei 225.

• A capped put is a combination of two puts, short one put with a higher exercise price and long an otherwise identical put with a lower exercise price. Here the two strike prices are 31,870.04 and 23,902.53. The capped put precludes the investor (Japanese life insurance companies) from having to pay the issuer (negative redemption) should the Nikkei fall below 23,902.53 at expiration. The capped put is out-of-the-money because the two strikes are well below the current level of the Nikkei at issuance (38,200).

• The instrument is coupon guaranteed by not principal guaranteed. The principal component has four times leverage.

• The investor picks up 90 basis points in enhanced coupon for writing the capped put.


21

Debt Issuance

• Graphically, the redemption formula looks like the following:

% Redemption

100%

Slope = 4

0%

23,902.53 31,870.04 Nikkei 225 at Maturity


22

Debt Issuance

• Skopbank will seek to “reverse engineer” the issue and, economically speaking, get back to floating dollar funding at sub-LIBOR. Skopbank will need to achieve a sub-LIBOR funding rate because (a) otherwise it would just issue floating dollar funding in the first place, and (b) it will assume some counter party credit risk with Goldman.

• Specifically, Skopbank will look to sell off its embedded capped put to Goldman (enter Goldman’s equity derivatives desk) and to convert the Yen-denominated fixed coupon obligation to a floating dollar obligation (enter Goldman’s cross-currency interest rate swap desk). Skopbank will convert the Yen proceeds from the issue into dollars, and reconvert dollars back to Yen via the real principals on the swap.

• Note that I do not have the exact terms of the swap done in this deal, so the figures appearing on the next page are just representative.


23

Debt Issuance

• We have:

Capped Put on Nikkei

1-1/8% Commission (or

about $525,000)

Yen 6.7 billion (today)

100% + $LIBOR - 20 bps (in

one year on $46.5278 million)

$46.5278 million (today)

107% (in one year on

Yen 6.7 billion)

SkopbankGoldman

Sachs


24

Debt Issuance

• In this case, at the end of the day, Skopbank has issued about $46.5278 million at an all-in cost of 20 basis points below $LIBOR.

• How much money Goldman makes all-in depends critically on what it will fetch for the capped put. (In addition, Goldman will have to hedge the risks occasioned by the cross-currency interest rate swap transaction.) In this case, Goldman refashioned the Nikkei puts and resold them to retail investors as Nikkei Put Warrants listed on the Amex. (One might say that Goldman could profit if the implied vol of the embedded put was lower than that of the listed put it in turn sold.)

• On a forensic note, the Nikkei closed at around 23,000 at the maturity of the Skopbank issue.


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Debt Issuance

Case Study II: Goldman-Disney

• In 1985, Disney acquired Arvida (real estate inventories) and paid greenmail to Saul Steinberg

• As a result, Disney had a substantially more levered balance sheet and had a significant debt maturity profile problem. It had $862 million in debt ($215 million to acquire Arvida and $328 million to repurchase 4.2 million shares from Steinberg). TD/TA rose from to 43% from about 20% just one year earlier. Two-thirds of the total debt consisted of short-term bank loans and CP.

• Disney was rated a weak single A.

• Since 1983, Disney had a licensing agreement with a Japanese company related to Disney Tokyo. Gate receipts were rising and so were Disney’s Yen-denominated royalties, but the dollar had been depreciating, occasioning losses on the exchange component.


26

Debt Issuance

• Thus Disney’s treasury officers sought to solve both problems by, in part, issuing long-term debt in Yen, converting the proceeds to dollars and paying down some of the short-term bank loans and CP, and using the Yen-denominated gate receipts to service the debt.

• Being a weak single A, a Euro-yen issue by Disney could not float in the Eurobond marketplace.

• Disney could obtain a 10-year Yen term loan from a consortium of Japanese banks. The loan would be fixed rate with a s.a. coupon of 3.75% and up front fees of 75 basis points. The principal would be Yen 15 billion or, at an exchange rate at the time of about Y250/US$1, about $60 million. Thus the all-in cost of the loan, in Yen, would be 7.75% p.a. (r = IRR = 3.804% s.a. or 7.75% p.a.):

100.00 - 0.75 = 3.75/(1 + r) + 3.75/(1 + r)^2 + … + 103.75/(1 + r)^20.


27

Debt Issuance

• Goldman suggested an alternative strategy to Disney whereby it would issue a 10-year Euro-ECU bond and then swap to Yen. The ECU proceeds would be exchanged in the spot market for dollars and used to pay down some of Disney’s short-term debt, thus restructuring its debt maturity profile. The Disney Tokyo Yen-denominated royalties would be used to service the swap payments. (The ECU was a trade-weighted basket of Common Market currencies and the forerunner of today’s euro. At the time, the ECU was the second leading European currency behind the then West German mark.)

• Goldman had identified a AAA-rated French utility with an already outstanding Euro-Yen bond that had about 10 years to maturity and was yielding about 6.83% p.a. It also had a 10-year outstanding Euro-ECU bond that was yielding about 9.37%.

• So the question was, Could Disney issue Euro-ECU and swap to Yen at an all-in funding cost that was lower than the 7.75% p.a. rate on the Japanese term loan? And could Goldman and the French utility profit too?


28

Debt Issuance

• The terms of the Euro-ECU bond were:

Par: ECU 80 million (also about $60 million at the time)

Price: 100.250%

Coupon: 9.125% p.a.

Fees: 2%

Expenses: $75,000

Sinking Fund: 5-year straight line beginning in Year 6

Dollar/ECU: $0.7420


29

Debt Issuance

• Given these terms, the cash flows on the Euro-ECU issue occasioned an all-in funding cost to Disney of just 9.47% (the IRR from the cash flow stream below):

Year Cash Flow (million ECU) Year Cash Flow (million ECU)

0 78.499 6 (23.300)

1 (7.300) 7 (21.840)

2 (7.300) 8 (20.380)

3 (7.300) 9 (18.920)

4 (7.300)

5 (7.300)


30

Debt Issuance

• At this point we can readily see an arbitrage opportunity. Call it “relative credit spread arbitrage”. As the table below indicates, whereas the French utility being rated AAA has an absolute advantage in issuing in both ECU and Yen, Disney has a comparative advantage in issuing in ECU. Disney’s relative credit spread in ECU is just 10 basis points, whereas it is 92 basis points in Yen. Buyers of the Euro-ECU issue appear to be overpricing the issue. The difference between the two relative credit spreads is 82 basis points and represents the “pie” that can be sliced up among Disney, the French utility, and a swap dealer (presumably Goldman at first thought).

ECU Yen

Fr. Utility (AAA) 9.37% p.a. 6.83% p.a.

Disney (A-) 9.47% p.a. 7.75% p.a.

Spread 10 bps 92 bps


31

Debt Issuance

• So Disney should issue in ECU and swap to Yen, the result of which is for Disney to service the French utilities outstanding Euro-Yen debt and the French utility to service Disney’s Euro-ECU debt:

Yen Payments (A) Yen Payments(C)

ECU Payments (B) ECU Payments (D)

ECU78.5 million (from Euro-ECU issue) Yen (to

$60 million (to service short-term debt) service

Yen (from Disney Tokyo royalties) Euro-Yen

ECU Payments (to service Euro-ECU bond) bond)

ECU (from operating cash flows)

DisneyFrenchUtility

SwapDealer


32

Debt Issuance

• The next slide shows the actual cash flows on the swap. The swap dealer in this case turned out to be the Industrial Bank of Japan (IBJ), which was then AAA rated. (It could have been that the French utility demanded a better-credited counter party than Goldman on the 10-year swap.)

• The columns are labeled A, B, C and D and comport to the arrows labeled similarly in the previous slide.

• When one computes the IRRs using the cash flows in the columns, one sees that Disney’s all-in funding cost in Yen (from issuing the Euro-ECU bond and swapping to Yen) was just 7.01%. That is a savings of 74 bps versus using the Yen term loan (7.75%). IBJ took 6 bps and therefore the French utility saved 2 bps (giving a total of 82 bps).

• Conclusion: Disney funds in Yen at just 18 bps above a AAA despite being a weak single A.

• Discuss IBJ’s “hari kari” swap.


33

Debt Issuance

• Note that the swap cash flows ignore any fees baid to either IBJ or Goldman. The dollar/ECU was $0.7420 and the Yen/dollar was Y248. The initial Yen principal received by Disney from IBJ is relevant only to the swap transaction and the calculation of an all-in Yen financing cost. By exchanging the initial Yen for dollars in the spot market, Disney would obtain new dollar funding. The principal amounts for the French utility are strictly notional as no net new funding is obtained by the utility as a result of the swap.

• ECU/Yen Swap Flows (Million)

Disney Swap Flows: Fr. Utility Swap Flows:

(Paid to)/received from IBJ Received from/(paid to) IBJ

Year Yen (A) ECU (B) Yen (C) ECU (D)

0 14,445.153 (78.499) (14,445.153) 80.000

0.5 (483.226) 483.226

1 (483.226) 7.300 483.226 (7.350)

1.5 (483.266) 483.266

2 (483.266) 7.300 483.266 (7.350)

2.5 (483.266) 483.266

3 (483.266) 7.300 483.266 (7.350)

(table continued on next slide)


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Debt Issuance

Disney Swap Flows: Fr. Utility Swap Flows:

Paid to/(received from) IBJ Received from/(paid to) IBJ

Year Yen (A) ECU (B) Yen (C) ECU (D)

3.5 (483.266) 483.266

4 (483.266) 7.300 483.266 (7.350)

4.5 (483.266) 483.266

5 (1,808.141) 7.300 1,808.141 (7.350)

5.5 (1,764.650) 1,764.650

6 (1,721.160) 23.300 1,721.160 (23.350)

6.5 (1,677.670) 1,677.670

7 (1,634.179) 21.840 1,634.179 (21.880)

7.5 (1,590.689) 1,590.689

8 (1,547.199) 20.380 1,547.199 (20.410)

8.5 (1,503.708) 1,503.708

9 (1,460.218) 18.920 1,460.218 (18.940)

9.5 (1,416.728) 1,416.728

10 (1,520.450) 17.460 1,520.450 (17.470)


35

Debt Issuance

More Modern Applications:

During the second half of the 1980s and first half of the 1990s, interest rate derivative desks discovered that the call option embedded in a callable bond could be replicated by a swaption. As a result, underwriters, working with their interest rate derivative desks, schooled corporate treasury officers on how to issue a callable bond and then sell-off (economically speaking) the embedded call by writing a swaption. If the embedded call could be purchased cheaply by the corporate issuer, that is, the added coupon was small compared to a straight-bond alternative, then the corporation’s overall funding cost would be lower (than the straight-debt alternative) after selling off the call by writing the swaption. At the end of the day, the embedded call was cheaper if its implied vol was lower than that of the swaption. We have:


36

Debt Issuance

Issue callable bond (issue straight debt and buy back a call)

+ Write a swaption (sell off embedded call)

Issue straight debt(lower coupon than issuing straight debt

directly if the implied vol of the swaption is

greater than that of the embedded call)

Of course, the investment bank could help discover (or create) value for the buy-side under this same process. If the implied vol of the embedded call is greater than that of the swaption, then the investor - say a hedge fund that buys the debt issue under a 144A offering - could buy the bond (possibly financing the purchase in the repo market) and buy the swaption. To isolate the value more precisely, the buyer could hedge the credit risk of the bond with a credit derivative.


37

Debt Issuance

Convertible Bond Arbitrage:

This process is essentially being rehashed today in the convertible bond arbitrage game. The following attachment demonstrates how an investor can engage in volatility arbitrage related to differences in values between the embedded option in the convertible and an actual or synthetic option on the stock. (See attachment.)


38

Debt Issuance

• The issuance of convertible debt through 144A offerings has been growing substantially over the last two years. In 1999, convertibles accounted for about 17% of the total equity issuance market, which was $186 billion. In 2000, convertibles accounted for about 25% of a $216 billion market. And through May of 2001, convertibles claimed about 53% of a $90 billion equity issuance market. (Follow-on’s were 33% and IPO’s just 14%.)

• Reasons for the rise in convertibles include (a) demand by investors occasioned by convertible arbitrage plays as just described; (b) a growing recognition that convertibles offer some balance sheet benefits (e.g., firms do not need to report fully diluted EPS as they would under a straight equity offering); (c) an unwillingness to issue straight equity as firms view their common stock as “expensive currency” following the NASDAQ market crash; and (d) a willingness among better credits to issue convertibles (just 22% investment grade issues in 1999 as compared to 63% in 2001 to date).


39

Debt Issuance

• Indeed, some now argue that the flood of embedded stock options accompanying these convertible issues has created a “volatility crush” or “volatility overhang” in the equity market. It is a fact that the market has been “taking out” time value from options, perhaps because of an excessive supply of vol. Volatility traders who have been delta and gamma neutral but carrying negative vegas have generally profited in 2001 (whereas such a strategy was generally a loser for the preceding five years).

09/01/01goldman sachs: debt issuance copyright (c) 1998-99, marshall, tucker & associates, llc....

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