A synthetic zero coupon bond is a security that has similar risk/return characteristics to a directly issued corporate zero coupon bond but has better relative value. Stripped coupon securities exist to bridge the gap between investor and issuer preferences. Most issuers do not sell zero coupon bonds for one of three reasons: (a) because of the proportionately large face amount required to achieve a fixed funding objective; (b) because in positive yield curve environments many issuers pay a higher interest rate on zero coupon bonds; (c) because the accreting nature of zero coupon bonds increases a company's leverage ratios unless the company retires debt each year.
The most basic structure is a synthetic zero coupon bond maturing on a fixed date. A special purpose vehicle is established to purchase a coupon bearing corporate bond and issue multiple classes of certificates each representing a single coupon payment or the final principal payment. An investor can purchase the synthetic zeros that fit their specific maturity needs. Absent any provision to the contrary, the entire principal claim would accrue to the benefit of the principal holder in the event the underlying bond is redeemed or is in default and is accelerated. Therefore, synthetic zero coupon bonds provide for allocation of any proceeds upon redemption or acceleration to each class based upon accretion schedules using the yield to maturity of each class on the issue date.
Applications
Investors purchase synthetic zero coupon bonds for several reasons, including:
• to increase duration and gain convexity;
• to obtain higher yields versus directly-issued zero coupon bonds; and
• to meet custom tenor and coupon targets. Synthetic zero coupon bonds are issued by a special purpose vehicle specifically designed to mimic the structural flexibility of medium term notes. The investor can thus set duration, convexity, call features, and maturity.
■ Example
An insurance company needs $100 million of 11.4-year duration assets to realign its portfolio with its benchmark index. Traditionally, this would be accomplished by buying $100 million 30 year corporate bonds, which in this example have a duration of 11.4 years and yield T+100 bps. Alternatively, the insurance company can purchase $38 million of a deferred coupon trust certificate that has a duration of 30.1 years and yields US T30 + 125 bps. The deferred coupon investment has a 0% coupon for years one through 20; at the end of year 20, the investor takes delivery of a 100-year coupon bond. On a dollar-weighted basis, $38 million of the trust certificate has the same duration as $100 million of 30-year coupon bonds and almost two times the convexity (for a 62% smaller investment amount). The insurance company also gets a return on cash of an additional 25 basis points versus current coupon 100-year bonds.
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