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because it is anticipated to be a good revenue source. Again, for our pur-
poses we simply want to advance the notion that tax policies influence how
market decisions are made, for issuers as well as for investors.

The higher yield spread is the result, all else being equal, of the difference in
structure of the FHLB callable product compared to the Fannie Mae product.

Market Environment

Like other bonds, municipal bonds have credit risk, market risk, and so
forth. In some instances the nature of the credit risk may be very different
from that of corporate securities (as with a municipality™s ability to gener-
ate tax revenues as opposed to profits in a more traditional business sense),
and may be quite similar to corporate securities in other instances (as when
a hospital issues revenue bonds that must be supported by successful ongo-
ing operations).
As an incentive for states and municipalities to have access to lower-cost
funding sources, municipal securities typically are offered with some kind
of tax free-status attached.
Since investors know going into the investment that they will be tax-
protected to at least some degree, they get a lower yield and coupon on their
investment. This lower coupon payment directly translates into a lower cost
of funding for the municipal entity. Often investors in municipal securities
monitor the ratio of municipal yield levels to fully taxable yield levels, as
one measure of gauging relative value on a broad basis between these two
asset classes. Ultimately, the investment decision of whether or not to invest
in municipal securities comes down to the matter of tax incentives.
Tax matters may not be the most terribly exciting of considerations when
it comes to strategy development, but they can be tremendously important
when it comes to the calculation of total returns and, hence, the making of
appropriate choices among investment opportunities.

Legal &

The legal environment of a given market is an extremely important consid-
eration. Yet the paradox is that although it is so important, it is also taken
for granted, so much so that it is often conveniently put out of mind as some-
thing requiring any significant deliberation. Certainly one of the criteria used
by the rating agencies when assigning currency ratings is some assessment
of the strength, independence, and effectiveness of judicial infrastructure. To
provide a picture or relevant legal considerations in the marketplace, let us
use the triangle of product, cash flow, and credit as our point of reference.
As to equities, a battery of registrations is typically required for a com-
pany to have its shares listed on an exchange. Filings typically must be made


not only with the exchange itself, but with governmental agencies as well.
Among the more rigorous of registration requirements, significant details of
present and past dealings may be demanded of the company™s board of direc-
tors and officers, and restrictions may be placed on when and how the equity
is retained or sold by company insiders. Clearly it is to a potential investor™s
advantage to know what protections do not exist and especially when the
investment involves an IPO and particularly when the IPO is being brought
in a market that is foreign to an investor™s.
For currencies, transactions occur in an over-the-counter (OTC) mar-
ket. The only rules and regulations typically encountered include consider-
ations of types and amounts of cash transfers and if exchanges of different
currencies are being done at the officially set exchange rate or at some black
market rate (as relevant, of course, only for those countries that do not allow
for a freely floating market-determined exchange rate).
Bonds also are an OTC market, yet various rules and guidelines exist
at national and local levels to help ensure fairness in buying and selling secu-
rities. For both currencies and bonds, investors are well advised to be aware
of a given market™s best practices, especially if it is not the investors™ home
As the structure of financial instruments grows more complex, legal con-
siderations may become more complex as well. For example, if a bundle of
existing bonds were packaged together as a single portfolio of securities, and
if the securities were originally brought to market as U.S. dollar-denominated
issues, what special legal considerations might arise, and especially if the cur-
rency exposure were transferred into euros via a currency swap? Let us con-
sider this a piece at a time. First, we consider the bundled aspects of the bonds.
When investors purchase a single security, typically the investors must
pursue any actions that might be required should the security experience dif-
ficulty. For example, if investors were to buy high-yield bonds, they would
have to pursue remedial action if that security became distressed or defaulted.
By contrast, if a bundle of high-yield securities were formally packaged and
sold as a single product, individual investors would not be as likely to be
the ones to bear the responsibility for seeking remedial action if one or more
of the securities within the bundle experienced difficulty. Typically when this
type of structured product is created, the entity arranging the structure makes
provisions for how distressed/default situations are to be handled and
charges an up-front and/or ongoing management/servicing fee. Clearly, it is
imperative that investors understand that they have delegated an apprecia-
ble amount of authority and control to someone else as pertains to legal pre-
rogatives. Investors should make necessary inquiries to be reasonably assured
that the entity(s) handling the legal end of things is reputable.
The swapped component of this example introduces yet another layer
of potential legal considerations. Many types of swaps might be executed,

Market Environment

including currency swaps, interest rate swaps, basis swaps, and index swaps.
A common element to all of these swaps is the embedded promise to make
good on all cash flows provided over the life of the swap. This is pretty con-
sistent with the promise embedded in a bond that pays coupons. Yet if a swap
is combined with a bond (as might be done to convert the original currency
exposure of the bond into something else), two levels of legal considerations
are brought into play. First, if an industrial company issued the bond, there
would be remedial action with this entity in a distressed/default situation.
Second, if a currency swap were then to overlay the industrial company
bond, it is doubtful that the industrial company would be providing investors
with the currency swap as well. Typically, investment banks would provide
the currency swap. Accordingly, investors must know the rules of the game
as they relate to a distressed/default situation of the underlying bond (the
industrial company), and of the investment bank providing an essential over-
lay to that underlying bond (as with the currency swap). But we do not have
to go all the way down to the distressed/default end of the continuum to
appreciate key legal dynamics of adding structural dimensions to standard
product types. For example, investment banks can be upgraded and down-
graded by the rating agencies, just as everything else can. Continuing with
the industrial company example, let us say that both the industrial company™s
bond and the investment bank providing the currency swap were initially
rated as double-A and that the investment bank subsequently was down-
graded to a triple-B entity. This event would have the effect of lowering the
credit profile of the combined products to single A, due to no fault on the
bond issuer™s part. Once again it is instructive to make a distinction between
investors buying the bond and the currency swap as a prepackaged bundle
or purchasing them separately. The prepackaged bundle approach implies
the presence of someone doing the structuring on behalf of someone else and
charging some kind of fee (typically embedded in the product™s overall price)
for that service. What must be made clear in this model is who will be
responsible for what; where does accountability ultimately lie?
For example, let us say that issuer A approaches investment bank B
about structuring one of its bonds with a currency swap so as to expand its
marketing and investor profile overseas. Let us also say that investment bank
B structures this bundled transaction, yet does so with the currency swap
component coming from investment bank C. Assuming that the deal was
successfully put together and sold in the marketplace, who is responsible for
what if investment bank C is downgraded (forcing a downgrade of the trans-
action and a concomitant decline in its price)?
Should investment bank C be expected to provide an injection of capi-
tal to the business unit underwriting the swap so as to improve the credit
quality of the products issued by that entity? Should the issuer set aside mon-


eys in a reserve fund to appease the rating agencies so that investors are fac-
ing a better implied outlook on their investment? Is there any role or
responsibility for investment bank B?
It is too late to ask these questions after a downgrade has been experi-
enced. These matters should be clearly laid out with a prospectus and ought
to be fully addressed before a purchase is made. A prospectus is a document
that accompanies a security when it comes to market. It ought to provide
relevant details pertaining to legal protections. Within bond prospectuses
these types of provisions are commonly referred to as covenants.
While convenants may be welcome in some instances (as with some con-
sumers who might not otherwise be familiar with the unique risks associ-
ated with investing in hedge funds), they may not be so welcome in other
instances (as with hedge funds that want their offerings to be more accessi-
ble to small investors).
Simply put, covenants help to bring greater precision to how exactly a bor-
rower intends to act once it receives its borrowings and/or how the borrower
intends to respond to particular events (anticipated or otherwise) while its debt
is outstanding. There are generally three types of covenants to consider.

1. Some covenants attempt to guide the nature of an issuer™s future pledges
against assets. Limitations on liens, sometimes called a negative pledge,
prohibit a company from granting a lien on an asset in favor of future
debtholders unless the lien also would benefit existing debtholders.
2. Some covenants attempt to guide the nature of an issuer™s future indebt-
edness. For example, an issuer might be restricted from additional debt
that it (or its subsidiaries) can take on or guarantee.
3. Some covenants limit certain payments, such as payments of dividends
and/or equity buybacks (when a company purchases shares of its own
stock in the open market) where a significant decapitalization (when a
company™s overall level of capital is decreased) could occur.

While some people believe that covenants really just serve the interests
of investors, issuers certainly stand to benefit. Generally the market tends
to prefer certainty to uncertainty. When a company™s present and future
actions are codified (not necessarily in detail, but certainly in meaningful
ways regarding financial operations), this information is valuable to
investors. At the same time, this road map is presumably of assistance to the
company™s management. Further, to the extent that the covenants provide
for certain measures in the event of severe financial difficulties, investors
would be less likely to demand a premium for the uncertainty associated with
such difficulties (as with default). In sum, as investors are likely to reward
greater certainty with a lower credit premium on the securities they purchase,
issuers presumably would welcome that greater certainty. It is a balance of

Market Environment

interests. At the same time that investors desire reasonable assurances, they
certainly ought not want to limit a company™s ability to move nimbly in
response to market opportunities and exigencies as they occur.
Table 6.4 lists of the various types of covenants that can exist. It is not
enough that a particular prospectus might contain one particular covenant
type or another if the covenants are structured in such a way that they are
in some way (as with another contradicting convenant) rendered ineffectual.
For example, an entity may be able to point to a limitation of indebtedness.
This means that the issuer pledges to limit the amount of additional debt it

TABLE 6.4 Various Covenant Types
Covenant Type Description

Change of control In its most basic of forms, restricts any one or more related
entities from acquiring over 50% of the voting shares in the
borrower or its parent group.

Cross default Intended to place the debt on equal footing with covenants
embedded within any other company debt in the event of a
company-wide default.

Debt Limitations on indebtedness. May be defined in any
number of ways. For example, definitions of what
constitutes maximum levels of additional “borrowings”
may be strictly articulated.

Debt coverage Promises related to sustaining ability to make good on debt
obligations. May be defined in any number of ways. For
example, definitions of what constitutes minimum levels of
“profit” may be strictly articulated.

Disposal restriction Limitations on when and how assets may be sold.

Negative pledge A restriction on the issuer regarding commitments of assets
that can be made on future borrowings. An exemption might
be permitted in the case of new companies being acquired.

Pari passu A common companion to the negative pledge, the pari
passu provision restricts the issuer in subordinating a
borrowing in deference to future creditors.

Payment limitations Can include restrictions on the company™s future payments
on non-debt instruments (as with dividend payments on
equities), or on the type of investments it might be
permitted to make.


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