Bond Types

What is a Step-Up Bond

A step-up bond is a type of variable note.  The step-up bonds coupon increases at regular intervals until the bond reaches its full maturity.  These higher rates are predetermined when the bond is initially purchased.  The benefit of this type of bond is that an investor does not have to concern themselves with how the price will fluctuate relative to the market index, since the higher coupon rate is fixed.  Step-up bonds are generally issued by government agencies. 

Example of  a Step-Up Bond

Let's say an investor purchases a 5-year step-up bond from Company A.  This step-up bond has a rate of 3% for the first three years and 5% for the last two years.  The benefit of the step-up bond is that the investor will usually receive the initial coupon above the market and will know exactly what to expect from their bond over the long-term.

Downside of Step-Up Bonds

While step-up bonds have the allure of the increasing return over time, the downside is that the bonds are callable by the issuer.  So, if interest rates fall to 3% but the step-up bond rate is 7%, the issuer will recall the bond and issue it at the lower rate in order to reduce the cost of borrowing.

What is a Credit-Linked Note?

A credit-linked note (CLN) is a derivative which offers synthetic exposure on an credit default swap (CDS).  The difference between a CDS and CLN is that the credit-linked note is an on-balance sheet item.  CLNs are primarily used for credit default swaps, but can be used as a hedge for other forms of debt.  A company looking to spread its risk for a specific credit event will look to issue CLNs in order to transfer this exposure to credit investors.  Special Purpose Companies (SPC) or trusts create the CLNs, which start out with a AAA credit rating and then act as a broker between the credit issuer (company) and credit investors.  These notes are offered to investors as both a credit default swap (riskier investment) and the AAA bond at par value.  Credit investors are willing take on this credit risk in hopes of receiving a higher yield on their investments than with typical bonds.  The trust or third party will then sell default protection in retrun for a premium that subsidizes the coupon payments to be made to the holder of the CLN.  Hence the credit investor has exposure to both the CLN and the credit issuer. 

Effects of Credit-Linked Notes on the Global Market

The credit crisis of 2008 has brought a lot of public scrutiny to the credit derivatives market.  Lehman Brothers was one of the companies which received such a public thrashing.  Lehman Brothers had sold billions of dollars worth of credit-linked notes to investors in Hong Kong, packaging them as mini bonds.  These mini bonds were sold as a low risk investment with a third party insurer in the event the bonds were worthless.  Well. once Lehman went under, it left a number of investors with bonds that were not worth the paper they were printed on.  Many investors in Hong Kong are outraged because the CLNs were sold by sales people who emphasized that the CDS were packaged with a "safe" bond with a AAA credit rating.

Credit-Linked Notes Chart Example

Below is a chart of example of relationship between the trusts, credit investor and the credit issuer.


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What are Liberty Bonds

After the wake of the horrific attacks on September 11th, lower Manhattan lost roughly 13 million square feet of office space.  The estimated costs for this rebuilding effort was $20 billion on the low end up to $50 billion on the high end.  Estimates for the World Trade Center alone were $7 billion.  Such a huge undertaking required enormous amount of financing.  This proved challenging for many real estate developers as there was no equity in the buildings and due to the risks associated with the loans, they came with high interest rates.  This is where the government stepped in to assist New York with getting back on her feet.

Congress Passes Liberty Bond Legislation

Congress took a proactive measure and passed the Job Creation and Worker Assistance act in 2002 which included many provisions to assist in the rebuilding of lower Manhattan.  The Liberty Bond legislation created a pool of $8 billion in tax-exempt financing from which New York City could extend to developers.  This has allowed commercial developers to secure financing at a much lower rate, with the expectation that once the projects are complete, the loans will be converted to fixed rates, and the rents secured from the buildings will be used to pay down the loans.

Requirements for receiving Liberty Bonds

Like the recent bailout offer from the government, the Liberty Bond has a lot of oversight in order to reduce the risk of fraud.  Below are just a few of the requirements for receiving financing under the Liberty Bond:

• Bond must be issued prior to January 1, 2005
• Minimum of 95% of costs must be used for qualified project costs
• 50% or more of bond proceeds must be used for rehabilitation purposes