Enhancements

Fix-to-Float and Changes to Payment Frequency, Day Count and Business Day Adjustments

Some securities are now issued in which the initial coupon is fixed but changes to a floating coupon after a specific number of accrual periods. Usually, when the coupon is fixed, it pays like a vanilla corporate bond having a semi-annual payment frequency, a 30/360 day count, and coupon payment dates without business day adjustments. However, once the coupon starts to float, the payment frequency becomes quarterly, the day count becomes ACT/360 and payment dates are business day adjusted. Our calculators support all of these changes and because we accurately project the cash flows for these instruments, the risk measures are precisely reported. We calculate the correct accrued interest within each accrual period which may be helpful for your back offices or administrators who are reconciling with Kynex.

A classic example of a fixed-to-float bond is US Bank (USB) maturing on 4/29/2020 (90333WAG3). On 11/10/2011, this bond was trading around 103.20. Below, we show the Kynex corporate valuation as well as the coupon schedule. Since this bond eventually floats, we give you two ways of looking at this security. As a regular bond, it yields 3.9462 to maturity. As a floater, its discount margin is 197.35 to maturity.

As is the case here, these fix-to-float structures commonly have a call between the fixed and floating payments. The details are illustrated on the cash flows.

Please note that the future coupon payments become quarterly after 4/29/2015. Also, coupon payment dates are business day adjusted. We project 3 month Libor even when the coupon is fixed. This facilitates the analysis of this bond on either a fixed basis or on a floating basis. In this example, the bond settles on 11/16/2011 with an accrued interest per $100 of 0.1784 (17 days from 10/29/2011 to 11/16/2011 based upon 30/360, and 0.1784 = 3.778*17/360). Note that the total interest in the first floating accrual period (from 4/29/2015 through 7/29/2015) is $9,719.17, which is based on an ACT/360 day count of 91 days (not on a 30/360 day count of 90 days).

In order to see the analysis if settling in the float period we can consider a fixed-to-float bond ILFC E-Capital Trust I, maturing on 12/21/2065 (44965TAA5). On 11/10/2011, this bond was trading at around 69. It settled on 11/16/2011 with an accrued interest per $100 of 0.2959 (56 days from 9/21/2011 to 11/16/2011 based upon ACT/360, and 0.2959 = 1.9025*56/360).

Please note that yields are expressed slightly differently for these two bonds. For the US Bank bond, the yield of 2.7989% is a nominal semiannual rate, as expected because it is settling in the fixed period. However, the yield of 6.328% is a nominal quarterly rate, the same as any corporate bond that pays quarterly.

Accretion Methods

To handle the recent nuances of various accreting structures in the market, we now support three additional accretion methods: Principal Only, Principal Only (CD rollover) and Straight Line. Principal-and-Interest is the most widespread accretion method and has always been supported by our calculators. Note that this accretion method is directly comparable to a bond yield (compound interest from settlement to the next coupon date). We have seen these three new accretion methods used in new issues, exchange offers as well as in zero coupon accreting bonds when the Co-Pa has been triggered. The new accretion methods will more accurately value the small percentage of structures that have these features. If a non-standard accretion method is used by the issuer, we show the true accretion rate for a direct comparison to the standard Principal-and-Interest rates. Some examples are below.

Principal Only Accretion

An example of a Principal Only is the School Specialty Exchange bonds due 2026 (807863AM7). The bond pays a 3.75% coupon and accretes at 3.9755% using the Principal Only method. Although the Principal Only accretion is constant, the true accretion rate (Principal-and-Interest) starts at 7.7808% and declines to 6.0331% at maturity. The longer you hold the bond, the slower the true accretion.

Principal Only (CD Rollover) Accretion

Powerwave Technology (PWAV) 2.75% due 2041 (739363AJ8) illustrates the need for Principal Only accretion using a CD rollover accumulation method. The bond pays 2.75% coupon and accretes at 5%. However, the first coupon period is short (the dated date is 7/26/2011), but the accreted value on the first coupon date (1/15/2012) is $1,023.47 (as stated in the Indenture). This accreted value is only correct if you assume simple interest between 7/26/2011 and 1/15/2012. Usually, compound interest is used by the issuer. The two methods for this period are shown below for comparison using a total of 169 days in the first coupon period using a day count of 30/360. We also include the true accretion rate calculation as well, which is consistent with how corporate bond yields are calculated.

Principal Only (CD Rollover) Simple Interest: $1000*(1 + (5/200)*(169/180)) = $1023.47222

Principal Only Compound Interest: $1000*(1 + 5/200)^(169/180) = $1023.45445

True Accretion Compound Interest: $1000*((1 +7.75907397/200)^(169/180))-12.9097222 = $1023.47222

For normal accrual periods, the two Principal Only methods will always give the same values on coupon dates, and slightly different values between coupon dates if the coupon is nonzero.

Price/Yield Analytics Using Foreign Benchmark Curves

Spread comparisons between corporate (non-convertible) bonds denominated in different currencies can be difficult. Kynex now provides the flexibility of valuing a bond using a benchmark curve denominated in a currency different from that of the security. For example, consider Ship Finance International 8.5% 12/15/2013 (824689AC7) trading on 11/14/2011 at 96. It is denominated in USD, and spreads versus the swap curve are shown below. Suppose you do not have a market quote for Telenet 9% 12/15/2013 (7742424), but after doing your balance sheet homework, you decide this bond should be priced similarly to the Ship Finance bond. The problem is that the Telenet bond is denominated in EUR. The solution is to calculate the spread of the Ship Finance bond over the EUR swap curve, and apply that same spread to the Telenet bond in order to arrive at a price indication of 95.62.

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Kynex provides this flexibility by first converting the future cash flows of the Ship Finance bond into EUR by using implied forward FX rates. The flows can then be discounted at a spread over the Euro swap curve. The resulting full price is then converted back to USD using spot (at settlement of the bond). The FX rates used are displayed on the cash flows.

The interest parity calculation can be seen in the table below.

PIK Bonds & PIK Toggles

Pay-In-Kind (PIK) corporate (non-convertible) bonds are now supported by Kynex. PIK bonds generally have two phases. Generally, the PIK bond at issue is in its accumulation phase. The issuer has the option of foregoing making cash coupon payments and instead paying all interest in additional debt (more bonds). The holder of the PIK bond accumulates more bonds up until the date in which the issuer must start making cash payments. The coupon date before the first mandatory cash payment is referred to as the PIK date. Before the PIK date, the holder is accumulating bonds. After the PIK date, cash coupons must be paid. A PIK bond settling beyond the PIK date is said to be in its payout phase. PIK issuers do not generally pay in cash unless they must. Sometimes, the issuer will pay one coupon rate if the payment is in cash and another (usually higher) coupon rate if the payment is in bonds (PIK toggle).

An example of a PIK bond still in its accumulation phase is Energy Future Holdings 11.25% 11/1/2017 (292680AD7). On 11/23/2011, it was trading at about 82. Historically, PIKs in the accumulation phase are quoted with a full price (trades flat) and are traded ex-coupon. This bond pays coupons to the holders of record on the 15^th of the month prior to the coupon dates (5/1 and 11/1).

The cash flows provide additional detail and analysis. The price of 82 is a dirty price per $100 of current face.

Yields and other P/Y measures are based upon the “Total Cash Flow” column. Unless otherwise specified, the analysis assumes a 100% PIK payment. The “Bond Interest” column gives the amount of interest assuming all cash coupons with no future growth in face amount. The “Pik Pay” column shows the amount of the PIK payment for that accrual period. The “PIK Interest” column gives the amount of interest paid (or lost) because of PIK payments in current or past accrual periods. The “Additional Face” column shows the accumulated face amount as of the start accrual date. If you sum the total interest paid assuming 100% PIK payments ($632,025) and compare that to the total interest paid assuming 0% PIK payments ($675,000), you will see that the PIK never catches the regular paying bond even though the PIK coupon is higher than the cash coupon. You can also see that by entering a PIK percent equal to zero on the corporate valuation.

The All Cash Yield is equal to 16.335%, while the PIK yield is 15.9874%, so you give up almost 35 bps for the PIK at a price of 82. Please note that any PIK percentage between 0 and 100 can be entered.

There is both good news and bad news when it comes to PIKs. The bad news is that PIKs invariably are called before the PIK date despite being issued by cash distressed companies (e.g. Univision 9.75% 3/15/2015). Some go bankrupt. The good news is that they solve the reinvestment rate problem during periods of low interest rates (like now). As mentioned above, you lose 35 bps in yield, but the return is another story. Assuming a 100% PIK, the yield was 15.9874% with a return rate of 13.591%. This return rate assumes a risk free reinvestment for every cash payment from settlement to maturity using implied forwards. If all payments are in cash, the yield of 16.335% is higher but the return rate of 12.829% is lower. So, you lose 35bps in yield but gain 76 bps in return. A PIK that survives is a thing of beauty in low interest rate environments.

An example of a PIK bond currently in its payout phase is Dollar General 11.875% 7/15/2017 (256669AG7). PIKs in their payout phase trade like a normal corporate bond. On 11/22/2011, the Dollar General bond was trading at about 110.50. Kynex does warn you that prices are now interpreted as clean.

The historical cash flows will show the past PIK payments. It should be noted that the issuer stipulated an initial all cash payment on the first coupon date. This initial payment can be seen below.

A floating rate PIK that has also reached its payout phase is the Noranda Aluminum Acquisition bond maturing on 5/15/2015 (65543AAB0). On 10/20/2011, this bond traded at around 92.

Note that the PIK coupon is 475bps over 6 month libor. You can evaluate this bond in terms of yield (7.5824%) or in terms of discount margin (659.48 bps). Past interest and PIK coupon payments are shown in the historical cash flows.

The issuer stipulated that the payment on the first coupon date would be all cash. For the next two payments, the issuer also chose to pay all cash. In the above table, it should be noted that the coupon for the accrual period beginning on 11/15/2011 is projected (on 10/20/2011) to be 4.7041%. If a later trade date in December is used for example, the actual coupon paid has reset to 4.6586% (on 11/11/2011) for that accrual period.

The actual coupon history is summarized below from the table above.