Stop the Swap

We have received from subscribers who have been approached by fixed income marketers suggesting swaps out of seven-year high-coupon corporate senior bonds into 10-year subordinated bonds of the same issuer, often with lower coupons. The typical yield pick-up has been in the 60 basis point area. This kind of swap is unattractive and ill-advised for several reasons. A swap (senior-to-senior or sub-to-sub) should allow investors to pick up at least the slope of the Treasury yield curve within the maturities of the swap. Currently, the slope of the U.S. Treasury curve, from the 7-year note to the 10-year note is about 55 basis points. If one was picking up 60 basis points swapping 7-year senior debt for 10-year senior debt that would be alright, albeit lackluster. One should always desire to pick up somewhat more than the slope of the curve to account for the additional credit risk which comes with extending out on the curve in the credit markets. However, if one is extending out on the curve AND dropping down on the capital structure (senior to sub), we sure as heck need to get better than a five or even a ten basis point pickup over the slope of the curve. However, the yield pick-up was not the main crux of these swap ideas. The main “selling point” was that one could lock in a profit on the seven year bonds and use the proceeds to increase face amount when buying the new bond. We ran the numbers (as we are apt to do) on one swap which encouraged investors holding 7-year senior bonds issued by a large investment bank with a coupon of 5.625% to swap into a 10-year subordinated bond, issued by the same investment bank, with a coupon of 4.875%. The yield pick-up was about 60 bps (+5 to the curve). Because the swap involved selling the 7-year senior bond at a significant premium and buying the 10-year sub note near par, one could pick up about eight more sub notes for every 100m senior bonds sold. However, because of the large drop in coupon, the swap resulted in a drop income. If one swapped 100m of the 5.875% senior bond for 108m of the 4.875% sub note, one’s semi-annual interest payment declined from 2,812.50 to 2,632.50, a decline of 180 every six months. If one swapped 100m seniors for 100m subs and took out the cash, one’s semi-annual income drops from 2,812.50 to 2437.50. That is a $750 annual decline in income. In our view (based on 24 years of fixed income experience) this swap makes no sense. We encourage subscribers to run any and all swap and trade ideas by Bond Squad before pulling the trigger. That is what you are paying us for, not just this newsletter.