A synthetic callable bond is a security that has similar risk/return characteristics to a directly issued corporate callable bond but has better relative value. Most investment grade corporate issuers prefer bullet funding and have a weak bid for the call option imbedded in callable securities. Therefore, callable securities tend to be priced expensively. A synthetic callable bond investor owns a trust certificate that evidences beneficial interest in (a) a non-callable bond and (b) a written covered call option. The certificate offers a higher yield than a callable bond sold directly by the corporate issuer because of the relative cheapness of non-callable bonds to callable bonds.
Advantages
Synthetic callable bonds have several advantages over directly issued callable bonds, including:
• They often trade at a higher yield for comparable credit/interest rate risk.
• They offer flexible investment terms. The investor can set the call price, call frequency, the coupon and maturity to better meet their risk and yield requirements.
• The much wider selection of credits increases the investor's ability to diversify. The majority of investment grade corporate issuers do not issue callable bonds. Callable bond investors can diversify into those issuers that only have non-callable bonds.
■ An Example
Corporation XYZ, an "A" rated issuer, funds itself by selling 10 year non callable bonds. The company swaps the fixed rate to a floating rate of LIBOR+20 bps. XYZ will issue callable bonds (generally "non-call two years; callable every six months thereafter") if a dealer or investor inquires, but has a funding target below LIBOR for this structure (XYZ swaps the callable issue to a floating funding rate) because XYZ has a preference for bullet funding.
Investors that want the higher yield that callables offer do not buy callable bonds issued by XYZ since none are outstanding. The synthetic callable bond fills this void. A grantor trust purchases an XYZ 10-year non-callable bond (which, as noted is 25 bps per annum cheap to a prospective XYZ callable bond) and sells a call option on this bond to Merrill Lynch or another investor.
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