Corporations can customize medium-term notes for institutional investors who want to make a market play on interest rate, currency, and/or stock market movements. That is, the coupon rate on the issue will be based on the movements of these financial variables. A corporation can do so in such a way that it can still synthetically fix the coupon rate. This can be accomplished by issuing an MTN and entering into a swap simultaneously. MTNs created in this way are called structured MTNs.

The following illustration demonstrates how an interest-rate swap can be used to create a structured note in which the coupon rate floats inversely with LIBOR; that is, an inverse floater. An inverse floater can be created from a fixed-rate security by creating a corresponding floater. By using an interest-rate swap, it is not necessary to create the floater.

FundsTo see how this can be done using an interest-rate swap, let’s assume the following. The Arbour Corporation wants to issue $100 million of a five-year fixed-rate MTN. The firm’s banker indicates that the yield it would have to offer is 6.10%. However, it recommends that the corporation issue an inverse-floating-rate MTN and proposes the following two transactions:

Notice that Arbour Corporation’s MTN is an inverse-floating-rate note because as LIBOR increases, the coupon rate decreases. However, although the MTN may have an inverse floating rate, the combination of the two transactions results in a fixed-rate financing for Arbour Corporation, as follows:

Arbour Corporation Receives:
From its banker for swap 7%
 

Arbour Corporation Pays:
To MTN holders

To its banker for swap Net payments:

 13% — LIBOR

LIBOR

(13% — LIBOR) + LIBOR — 7% = 6%

The advantage of this structured MTN is that the issuer was able to obtain a funding cost of 6% rather than 6.1% if it issued a fixed-rate MTN. By using other types of swaps (equity and currency), any type of coupon rate can be created.

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Creations of Structured Notes using Swaps