Tuesday, December 05, 2006

Range notes

I've recently got a couple questions about non-inversion and range notes. First, some background.

A range note is a bond that pays interest if a specified interest rate remains above or below a certain level and/or remains within a certain range. Most of the ones I've seen lately are structured something like a 6% coupon so long as 3-month LIBOR doesn't go above 8% or some such. Any day where the LIBOR rate is above 8%, no interest accrues. That's just an example, I haven't pulled up a specific issue. I've also seen range notes involving currency exchange rates. Normally the range note is issued by a large bank or other financial institution whose credit is behind the principal payment.

Valuing a range note is fairly straight forward. In the above example where there is a fixed coupon, you have two simple pieces. One is a 6% bullet. The other is a modified 8% LIBOR cap. Instead of a normal cap, this is more of a binomial cap, where you pay 6% every time you are above the cap strike. Either way, normal binomial tree methodology could be used to value the modified cap.

I don't own any range notes of this type. If I wanted to enter into a cap or floor transaction, I could. It almost has to be the case that entering into the derivative transaction yourself is cheaper than doing it via the structured note. I say this because the investment bank doing the range note is, in effect, selling the derivative to you. They wouldn't be doing this unless it was profitable for them.

Now, there may well be cases where you're willing to pay up for the derivative exposure the range note allows. First, it might be a situation where legally an entity can't use derivatives. This is pretty common among public authorities and municipalities. The range note may allow the entity to hedge certain interest rate exposures they would otherwise be unable to. Second, a small investor may not be able to buy the derivative due to size constraints. However, most small investors are not going to be able to properly value the pieces embedded in the structure, so there is considerable risk that small investors get plain ripped off.

A non-inversion note is basically a range note but where the "range" is the slope of the yield curve. I've seen them done based on LIBOR and Treasuries and usually the slope is 2-10 years. So as an example, the non-inversion note would pay 8% any time the slope between 2-10 years is positive, zero when its negative. The ones I've seen usually have a 1 or 2 year fixed period, meaning that the bond cannot be called and the 8% coupon is paid no matter what. After the fixed period, the 8% accrues every day the slope is positive, whereas nothing accrues on days where the slope is negative. So if the bond pays quarterly with a 30/360 accrual schedule, and the slope was negative one day during the quarter, you'd be paid 1.978% for that quarter or a 7.91% annual rate.

I view this more favorably than the straight range notes. First of all, the derivatives needed to reproduce a non-inversion note are not standard, widely traded structures. So to reproduce these bonds you'd need to buy something custom created anyway. Second, I believe there is a natural tendency for the yield curve to be positively sloped, and this is a tendency which will persist over time. That makes betting against inversion an easy call. Has recent foreign purchase activity caused the slope to be flatter than it might have otherwise been? Maybe, but remember that as recently as 2004 the 2-10 slope was over +200bps.

The issues are usually callable anytime after the fixed period is over. In all likelihood, the issuer will call the bonds as soon as they can if the curve has reverted to a normal slope. The bonds will only stay outstanding as long as the slope is negative or close to zero. Take that as a warning for anyone considering buying one of these.

Why are these issued? Most of the non-inversion deals have been done by investment banks or commercial banks. These are entities that abhor an inversion because it compresses their profits. I believe banks view issuing non-inversion notes as an insurance policy against long-term inversion. While historically, periods of inversion are usually less than a year, the banks just cannot afford a longer period of inversion, and are willing to pay for some amount of protection.


Anonymous said...

Great explanation

Anonymous said...

Is the market small enough for Dealers to short these non-inversion notes so that they don't have to pay the extra interest , or is it too deep ?

Accrued Interest said...

Not sure what you mean. Many of these have dealer firms as the underlying credit, so in essense the dealer has indeed shorted it. Lehman Brothers, Credit Suisse and Barclays have all done these.

The market is not deep at all. Deal sizes are in the 25 million range.

Anonymous said...

Tom, Any chance you would be available to manage/consult for the fixed income and yield components of a tax advantaged portion of a retirement account? If you would like to discuss further, I can leave an email address. wp

Accrued Interest said...


I can't do it personally for a few reasons, some ethical some legal. My firm has a $10 million minimum investment.

If that's not an issue, drop me an e-mail at arbitrager_1999 at yahoo.com.

Anonymous said...

Tom, (Email arbitrager_1999@ yahoo.com didn't work..so I'll try here) I post fairly often at Roger's blog. Today was the only day that I put an id..wp. (I tried to answer your question about Appel)
I have been quite taken by parity and the concept of an all wealther portfolio as well as the use of timing to manage risk. (I posted the primers) It's rare, for me, to find someone who wants to pursue both the passive and active investment styles. Though your complexities and depth are way beyond my grasp...I'm only trying to say how important investment style similarities and comfort are strongly related when looking for an asset manager. My 401k is worth a large sum but not 10million. I was going to manage it myself , as I had been doing until I recently retired, but frankly it is proving too stressful as I get to know more and more what I don't know. I have one candidate, not want to mention his name publically..he's in your neck of the woods geographically speaking and almost exclusively uses momentum trading of different, low correlation asset classes. If you have any other suggestions please let me know. Ideally, I can find someone to do both the momentum part and the more passive approach with an emphasis on yield. my email:

Jayne said...

Thanks so much for this post, pretty helpful data.