Callable step-up notes are callable debt issues that feature one or more increases in a fixed rate or a step-up in a spread over LIBOR during the life of the note. Most issuers of these notes have low credit ratings. Consequently, the purpose of the step-up is usually to encourage the issuer to refinance. If the issuer does not refinance, the higher rate is designed to be compensation for the investors acceptance of credit risk. Highly rated issuers sometimes issue step-up bonds if they believe that interest rates will decline and they can issue a replacement bond at a lower rate.
Step-Down Coupon Note
Step-down coupon notes are debt instruments with a high coupon in earlier payment periods and a lower coupon in later payment periods. This structure is usually motivated by a low short-term rate environment and regulatory or tax considerations. Investors seeking to front-load their interest income would be interested in such notes.
9.4 Summary and Conclusions
Multinational corporations can use creative financing to achieve various objectives, such as lowering their cost of funds, cutting taxes, and reducing political risk. This chapter focused on two such techniques—interest rate and currency swaps and interest rate forward and futures contracts.
Interest and currency swaps involve a financial transaction in which two counterparties agree to exchange streams of payments over time. In an interest rate swap, no actual principal is exchanged either initially or at maturity, but interest payment streams are exchanged according to predetermined rules and are based on an underlying notional amount. The two main types are coupon swaps (or fixed rate to floating rate) and basis swaps (from floating rate against one reference rate to floating rate with another reference rate).
Currency swap refers to a transaction in which two counterparties exchange specific amounts of two currencies at the outset and repay over time according to a predetermined rule that reflects both interest payments and amortization of principal. A cross-currency interest rate swap involves swapping fixed-rate flows in one currency to floating-rate flows in another.
Interest forward and futures contracts enable companies to manage their interest rate expense and risk. These contracts include forward forwards, forward rate agreements, and Eurodollar futures. All of them allow companies to lock in interest rates on future loans and deposits. A forward forward is a contract that fixes an interest rate today on a future loan or deposit. The contract specifies the interest rate, the principal amount of the future deposit or loan, and the start and ending dates of the future interest rate period.
A forward rate agreement is a cash-settled, over-the-counter forward contract that allows a company to fix an interest rate to be applied to a specified future interest period on a notional principal amount. Eurodollar futures, which are based on a three-month, $1 million Eurodollar deposit that pays LIBOR, act like FRAs in that they help lock in a future interest rate and are settled in cash. However, unlike FRAs, they are marked to market daily. Eurodollar futures contracts are traded on several U.S. and overseas exchanges.
Structured notes are complex debt instruments whose payments are tied to a reference index, such as LIBOR, and have one or more embedded derivative elements, such as swaps, forwards, or options. However, they do perform a valuable function. They allow corporations and financial institutions to function more efficiently by enabling them to tailor financial products to meet their individual needs.