Special purpose vehicles (SPVs) facilitate asset repackaging by embedding credit derivatives in SPVs, allocating cash flows, or by tranching credit risk. Many investors are unable or unwilling to enter into interest rate swaps, default swaps, currency swaps or other derivatives directly. For some, credit availability is an issue; for others it is the additional resources required to document and manage separate derivative positions. SPVs accommodate investors' needs for various coupons, credit ratings, maturities, and volume, all in the form of a security. SPVs are generally structured to avoid entity-level tax.
The Global Credit Derivatives group at Merrill Lynch utilizes several SPVs, including:
• STructured EnhancEd Return TrustS (public and private STEERS®)
• Asset Backed Trusts (ABTs)
• Secured, Individually Repackaged & Exchangeable Securities (SIRES, Limited.)
• Loan Co.'s
• CBOs and CLOs
Each of the SPVs above are a series of bankruptcy remote trusts or companies that are established to purchase assets, use swaps and options, and thereby create a customized coupon, as shown below in Figure 8. The certificates or notes can be individually rated by one or more of the major ratings agencies (Moody's, Standard & Poor's, Fitch, and Duff and Phelps). The rating of an SPV will typically reflect the rating on the underlying security along with some consideration given to the rating of the derivative counterparty.
Applications
Investors utilize SPVs to increase market access. SPVs allow investors to buy a security with a customized coupon, currency, call features and tenor without entering into swaps, options or other over the counter derivatives directly. Use of SPVs also allows investors to benefit from efficiencies of scale. Because an SPV can hold multiple assets, bonds can be aggregated and purchased in a single, large transaction. The SPV coupon can be one aggregate round coupon, eliminating the need to process frequent and varying cash flows.
■ Examples• A corporate bond investor is looking for high yielding instruments with strong corporate names. America Online issues a subordinated zero-coupon
convertible bond at a high yield. Default swaps offer an opportunity for investors to purchase credit exposure directly, without worrying about the zero-coupon accretion or the embedded equity option. However, due to restrictions in their charter, the investor is unable to use derivative instruments as investment opportunities. Therefore, the investor purchases a STEERS with an embedded AOL default swap. The investor achieves a high yielding synthetic AOL bond that meets all charter restrictions despite the lack of any plain vanilla AOL bonds in the market.
• A money market fund cannot buy a five-year credit card asset backed security according to the Rule 2a-7 guidelines that govern money market fund investments. The fund could, however, purchase an ABT trust certificate that evidenced beneficial ownership in (a) those same securities and (b) a derivative contract with Merrill Lynch that converts the tenor of the security from five years to one year using a put option (which adheres to the guidelines for the fund). The investor has increased the fund's access to new investments and will often achieve a yield pickup over similarly rated investments. Merrill makes a secondary market in ABTs.
■ Documentation
Grantor trust transactions (e.g., STEERS® and ABTs) and special purpose companies (e.g., SIRES and Loan Co.'s) have similar documentation. The transactions are described in an offering memorandum and supplement. There are also documents that establish the vehicle: a trust agreement for trusts and incorporation documents for special purpose companies
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