SPV for principal-at-risk longevity bond

[welsh_owen]

Hi All,

I have been looking back through my notes and had a question regarding the SPV diagram included on page 14 of the notes in chapter 14.

I wondered whether there is actually a need for the Total Return Swap which would pay the SPV LIBOR + a margin?

If we consider the underlying fixed income assets in the portfolio would these not have known coupons? To my mind the fixed coupons received by the SPV (excluding default risk) could be structured to meet the fixed coupons paid to investors. I am not really clear as to why receiving a floating rate swap based on LIBOR would be beneficial under this scenario?

The other option of course could be that the coupons the investors receive are based on the prevailing floating rate received under the swap and the TRS is used to smooth out the cash flow profile of the bond portfolio.

If the portfolio contained bonds which paid coupons at a floating rate and an asset swap was then used to receive a fixed rate this would appear to make more sense to me as we could structure our known coupons paid to investors with certainty.

If the TRS which pays a floating rate to the SPV were adopted and LIBOR rates dropped significantly (as they have done over the last 3 years) what would happen in the situation when the SPV could not meet the fixed coupons paid to investors?

 

[Mike Lewry]

Hi All,

I have been looking back through my notes and had a question regarding the SPV diagram included on page 14 of the notes in chapter 14.

I wondered whether there is actually a need for the Total Return Swap which would pay the SPV LIBOR + a margin?

No, there's no need for this. It's an optional extra, that, personally, I think just confuses things.

If we consider the underlying fixed income assets in the portfolio would these not have known coupons? To my mind the fixed coupons received by the SPV (excluding default risk) could be structured to meet the fixed coupons paid to investors. I am not really clear as to why receiving a floating rate swap based on LIBOR would be beneficial under this scenario?

The key to this is your bracketed comment "(excluding default risk)". If the SPV is holding defaultable bonds (either corporate or less-than-totally-secure government bonds), then a TRS would be atttractive. Ideally we'd want a TRS that paid out a fixed rate, but the diagram is assuming these are not attractively priced and so they've gone for a floating rate instead.

Unfortunately, this introduces the risk of the floating rate falling, which you mention later. To protect against this, the SPV will need to contain extra assets to ensure the payments to investors can be met. The extra assets needed for this risk must be less than the extra assets that would have been needed to protect against the default risk, otherwise there'd have been no point in entering into the TRS.

 

[Foley]

Mike, this is confusing me too. The question I have is if, as you have pointed out in your response, the TRS protects against default risk, why is the SPV making payments to the Credit Enhancement Agency (it seems unnecessary)? Is this to protect against default by the TRS counterparty?

In Albert's presentation there was no Credit Enhancement Agency. Would the SPV pay a floating rate in practice (I presume they can do whatever they want in theory) as would seem to be the case from Albert's presentation?

Also, in the solution to Question 6.12, the swap is a floating for fixed (which seems more sensible!) and the ceding company rather than the SPV is paying the premium to the credit enhancement agency.

 

[Edwin]

Mike, this is confusing me too. The question I have is if, as you have pointed out in your response, the TRS protects against default risk, why is the SPV making payments to the Credit Enhancement Agency (it seems unnecessary)? Is this to protect against default by the TRS counterparty?

In Albert's presentation there was no Credit Enhancement Agency. Would the SPV pay a floating rate in practice (I presume they can do whatever they want in theory) as would seem to be the case from Albert's presentation?

Also, in the solution to Question 6.12, the swap is a floating for fixed (which seems more sensible!) and the ceding company rather than the SPV is paying the premium to the credit enhancement agency.

The Core-reading says where there is deemed to be any residual risk, the CEA is used. It goes to say the TRS is not credit-risk free as was observed with the collapse of Lehman Brothers when a number of TRS failed to protect investors.

 

[Mike Lewry]

Good questions.

The TRS might cover just some of the assets, so the CEA might offer more complete protection.

The cashflows are just illustrative, so yes they might be different for an actual SPV in practice.

Yes, I like Q6.12, which is based on the SPV illustration that used to be in the Core Reading before it was changed a few years ago.

 

[Edward chong]

Further questions

Hi all,

Referring to "Special Purpose Vehicle" for longevity bonds on page 10 unit 15 of core reading for 2014 exams, I would like to ask that:
a) Are assets bought using total premium paid to SPV being earmarked as collateral assets?

b) Is over-collateralisation a must for a SPV to reduce counterparty default risk?

c) Assuming a principal-at-risk longevity bond that pays fixed nominal coupons to the investors, why would the SPV hold assets that yield floating rates and swap the returns with the TRS into fixed rates?

d) Do the variation margins (for swap with TRS) being included in the collateral assets or held in a separate account?

e) What are the examples for credit enhancement agency? Do they necessarily have a better credit rating than the SPV to reduce counterparty default risk?

Thank you!

 

[Mike Lewry]

Referring to "Special Purpose Vehicle" for longevity bonds on page 10 unit 15 of core reading for 2014 exams, I would like to ask that:
a) Are assets bought using total premium paid to SPV being earmarked as collateral assets?

Yes, the cash proceeds from investors plus the protection premium from the ceding company form the SPVs collateral assets.

b) Is over-collateralisation a must for a SPV to reduce counterparty default risk?

No, it's not a "must", but it will help to improve the credit rating of the SPV. But note, the price the investors pay will allow for the possibility of a reduction in the Notional and so at least some protection premium is required from the ceding company to allow the Notional to be paid in full if required.

c) Assuming a principal-at-risk longevity bond that pays fixed nominal coupons to the investors, why would the SPV hold assets that yield floating rates and swap the returns with the TRS into fixed rates?

These assets might currently be more attractive from a tactical investment perspective.

d) Do the variation margins (for swap with TRS) being included in the collateral assets or held in a separate account?

Rules for margin/collateral in relation to various types of swap contracts vary by country and knowledge of these details is not required for ST6.

e) What are the examples for credit enhancement agency? Do they necessarily have a better credit rating than the SPV to reduce counterparty default risk?

Methods for credit enhancement include:

• Overcollateralization
• Creating retianed spread (ie yield received on assets is greater than outgo and retained to create a buffer)
• Insurance (an inusurer guarantees to make payments if the SPV becomes unable to) The higher it's credit rating the better, but this doesn't have to be higher than the SPV's. Also the lower the correlation, the better.
• Letter of Credit (LOC) (from a bank with a higher credit rating)
• Structural Enhancement by creating tranches (subordinated tranches give greater security to higher ranked tranches). These are labelled Class A, B, C.