Special Purpose Vehicle (SPV)

Discussion in 'SP5' started by Jaishree19, Jan 16, 2021.

  1. Jaishree19

    Jaishree19 Made first post

    Hi,

    I was reading through the core reading, and came across the Credit Linked Note, and how it links to the structure of SPV. The example provided is as follows:
    " Suppose that the risky corporate bond yields 4.5% p.a., the risk-free Government bonds 4% p.a. and therefore that the credit default swap fee is about 0.5%.

    The regular cashflow prior to any default are then:
    1. Original Bondholder
    - received 4.5% p.a. from the corporate bonds
    - pays 0.5% p.a. credit default swap fee to SPV
    - leaving 4% p.a. net (i.e. the risk free rate)
    2. SPV
    - receives 4% p.a. from Government bonds
    - receives 0.5% p.a. credit default swap fee
    - giving total 4.5% p.a. (i.e. the risky rate)

    This 4.5% p.a. is then passed to the investors in the SPV, who effectively receive the risky return on the original corporate bonds in return for taking on board the full default risk."

    I'm trying to understand this example by seeing how the investors are absorbing the credit default risk, if the original bondholder is still receiving the 4.5% in the swap. Unless, the credit linked note sold by the original bondholder allows the SPV to act as the middle-man between the investor and the original bondholder in a credit default swap, where the original bondholder will pass on the return obtained from the corporate bond to the SPV to pass to the investor in return for a more certain (of close to guaranteed) 4% from the SPV (of which the SPV got the capital from the investor to purchase the government bonds to provide this return). so the investor's cash flow should be:
    - pays the bond value for government bond of 4% p.a. to SPV
    - receives the corporate bond return (which if no default is 4.5% p.a.)

    Is this right? Also, how does the SPV benefit from this structure? (Not sure if i'm overthinking this, but would really appreciate some help on understanding this example).

    Thanks!
    Jai
     
  2. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    You may be overthinking. the bond is still the possession of the original bondholder. They pay the premiums on the CDS to the SPV and unless a credit event is triggered the CDS will never crystallise. But if there is a triggered event on the corporate bond, the SPV will have to compensate the original holder for their losses, whatever those are. Those compensation payments by the SPV will require it to sell the government bond. Only part of the government bond value will be available to the SPV after the compensation has been paid. So investors will only get part of the government bond value when it is all over, so in effect they have suffered from the default of the corporate bond.
    How does the SPV benefit - it doesnt really. It is an administrative structure and doesnt make a profit or accep any risk. It charges a small levy from the original bond owner to ensure it can function, and it winds up when everything is complete. think of it as being a couple of lawyers in a room who charge their client every 6 months for administering the structure.
     
    Jaishree19 likes this.
  3. Jaishree19

    Jaishree19 Made first post

    Thanks Colin! I figured i was overthinking, and your analogy on the lawyers in a room made sense! (I think it was just bugging me on how the SPV was benefitting form the arrangement)
     

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