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of the bond™s face value, investors are reasonably assured of a means to mod-
erate their credit risk. Some latitude for loan defaults is allowed without an
undue influence on the overall credit standing of the securitized venue.
Moreover, the issuer is presumably happy with the lower coupon attached
to a triple-A asset-backed security as this means more of an economic incen-
tive to have its loans securitized in the first place.


Capital
Another way a company can secure a more favorable credit rating for one
of its financial products would be to obtain third-party insurance. In such
cases, a third-party says that it will guarantee the financial product™s main-
tenance of a credit rating of a certain minimum level over the life of the prod-
uct. In exchange for providing this guarantee, the issuer pays a fee (an
insurance premium). The benefit of such an arrangement to the issuer could
be a lower net cost of funds (since investors may demand less of a risk pre-
mium for buying a financial product that comes with guarantees) and the
possibility of reaching more potential investors by structuring its product in
such a way.
When an individual seeks to purchase a life insurance policy, insurance
companies commonly insist on seeing the results of a physical exam prior
to granting a policy. Upon seeing the results of that physical exam, the life



TLFeBOOK
92 PRODUCTS, CASH FLOWS, AND CREDIT



insurance company might refuse to issue a policy, issue a policy but with
higher premiums relative to what is charged to healthier customers, and/or
issue a policy but only after receiving assurances that particular changes are
made in the customer™s lifestyle. For example, the potential customer may
be a smoker, and an insurance company might insist that he quit before a
policy is issued.
Similarly, before an investment bank chooses to underwrite (assist with)
a particular firm™s securities, it is likely to want to give the firm a complete
physical. That is, it is likely to want to visit the premises and operations,
look over financial statements, and interview key officers. Further, it ulti-
mately may refuse to underwrite the firm™s securities altogether, or it might
insist that certain measures be taken prior to a policy being granted. Insisting
on major policy changes may be difficult with well-established companies;
often a simpler solution can be found. For example, the insurance company
might simply ask the issuer to set aside an allocation of capital that it
promises not to touch over the life of the security that is being guaranteed.
In doing this the issuer is creating a reserve, a special account whose sole
purpose is to provide a backup of dedicated financial resources in the event
that they might be required to support or service the firm™s financial prod-
uct. Clearly it would be disadvantageous for the amount placed in the reserve
to be equal to or greater than the amount being raised in the first place, so
appropriate terms and conditions have to be agreed on. A currency deposit
(which is hard cash, and which is spot5) is used to help secure a more desir-
able credit profile for an issuer™s financial product.
Another way an issuer can attempt to achieve a more desirable credit
profile for its financial products is with the creative use of another entity™s
capital structure. For example, if an issuer creates a financial product requir-
ing certain inputs that can be obtained from an entity outside of the issuer™s
company (as with an interest rate swap provided by an investment bank),
then the credit rating of that outside entity can contribute beneficially to the
overall credit rating of the product being launched. It is then desirable, of
course, that the outside entity™s credit rating be above the issuer™s rating and


5
Just as futures and forwards and options are derivatives of spot when speaking of
bonds and equities, cash has its derivatives. For example, the writing of a check is a
variation of entering into a forward agreement. Unlike traditional forward
agreements where goods are exchanged for cash at an agreed-on point in the
future, goods typically are provided immediately and with actual receipt of cash
coming several days later (when the check clears). In this fashion the use of a credit
card is also a derivative of cash. Of course, another variation of the forward
transaction is when payment is provided immediately for a delivery of goods that is
not to be made until some point in the future.




TLFeBOOK
93
Credit



that it remain above the issuer™s rating. Many investment banks have in fact
created triple-A rated subsidiaries or special-purpose vehicles (SPVs or spe-
cial entities created to help isolate and secure certain market transactions;
also known as a bankruptcy-remote entity and a derivatives product com-
pany) to assist with this type of creative product construction. Chapter 4 pro-
vides an explicit example of how the credit rating of a product can be directly
influenced by the entities involved with creating it.
To link yield-related phenomena across the first three chapters of this
text, consider Figure 3.2. Each successive layer that is added equates to a
higher overall yield for this hypothetical bond.
As another perspective on the relationship between credit and the way
securities are put together, consider Figure 3.3. As shown, credit risk most
certainly can be ranked by security type, and investors should take this real-
ity into consideration with each and every transaction.
Figure 3.3 is a conceptual guide to a hierarchy of relationships that can
exist between security types and associated credit exposure. There is latitude
for investors to place these or other security types in a different relation to
one another.



Callable subordinated non“Treasury coupon-bearing bond


Subordinated non“Treasury coupon-bearing bond


Non“Treasury coupon-bearing bond
Increasing credit risk




with standard features


Non“Treasury coupon-bearing bond
with strong covenants


Overcollateralized
non“Treasury coupon-bearing bond


Coupon-bearing Treasury bond


Note that this layering is done with the assumption
that the maturity of the Treasury and non-Treasury
securities is comparable and that the non-Treasury
securities are all issued by a single entity profile.

FIGURE 3.2 Layering of credit-related risks within bonds.



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94 PRODUCTS, CASH FLOWS, AND CREDIT



H Long-dated uncollateralized bullet
G Long-dated uncollateralized bullet with protective covenants
Credit Risk
F Long-dated uncollateralized putable
Protection
E Long-dated and collateralized
D Short-dated bullet
C Short-dated uncollateralized bullet with protective covenants
B Short-dated uncollateralized putable
A Short-dated and collateralized




Security Types
A B C D E F G H

FIGURE 3.3 Conceptual linking of credit risk with security types.


Table 3.2 is taken from a survey performed by Standard & Poor™s.
Within the very real world of recovering value from investments that have
gone bad, the table presents the relationship among various bonds and their
associated success with recovering monies for investors.


TABLE 3.2 Average Recoveries




[Table not available in this electronic edition.]




TLFeBOOK
95
Credit



As shown, the uppermost senior structures (bank debt and senior
secured notes) exhibit rather strong and favorable recovery statistics with
mean and median recovery percentages ranging from 63 to 100 percent. At
the opposite end of the spectrum (senior subordinated notes and junior sub-
ordinated notes), mean and median recovery percentages range from 5 to
28 percent. Clearly structure type matters (e.g., secured versus unsecured)
as does the particular ranking of a security within the capital structure of
its issuer (e.g., senior versus junior). Investors are well advised to take these
factors into consideration when evaluating various investment opportuni-
ties. A security™s standing in relation to the issuer™s capital structure, and
whether the security is secured or unsecured, collateralized or uncollateral-
ized, and so on, can have an important material impact on its value in a
worst-case scenario.
In a more recent study, Standard & Poor™s reported a dramatic differ-
ence between debt with a sizable cushion versus debt with a less sizable cush-
ion. Debt cushion is defined as the percentage of a company™s debt that is
inferior to a particular debt instrument. In other words, the larger the value
of a debt cushion, the more senior the debt instrument being considered.
Further, Standard & Poor™s segmented its debt cushion analysis into debt
without collateralized backing (unsecured) and debt with collateralized
backing (secured). Accordingly, consideration is made of both the relative
credit ranking of a debt instrument within a company™s capital structure and
its cash flow features. Table 3.3 summarizes the results and shows how a
product™s credit standing and structure of cash flows can have important bot-
tom-line implications for investors.



TABLE 3.3 Weighted Average Discounted Recovery Rates, 1987“2001




[Table not available in this electronic edition.]




The triangles in Figure 3.4 present a way to conceptualize this nature
of credit dynamics in the context of products, cash flows, and capital. At
each step a new consideration is added and with a positive effect on credit.
Of course, numerous combinations of cash flow, capital, and product struc-
tures can be engineered.



TLFeBOOK
96 PRODUCTS, CASH FLOWS, AND CREDIT




Issuer decides to collateralize Issuer™s generic long-
the debt. Rating is upgraded to term debt carries a
double A. rating of triple B.
Cash flows Issuer




Capital

Issuer decides to place the debt offering in the senior-most position of
its capital structure. Rating is upgraded to single B.


FIGURE 3.4 Incremental venues for increasing the credit quality of a bond.



Credit
Cash flows
Spot
Equities




The ultimate consideration with credit risk is that an investor has some mea-
sure of assurance of receiving complete and timely cash flows. For a coupon-
bearing bond, this means receiving coupons and principal when they are due
and with payment in full. For equities, this can mean receiving dividends in
a timely manner and/or simply being able to exchange cash for securities (or

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