US: Coming Soon - Attractive Entry Point for

Structured Notes
„ The sell-off in rates and steepening of the Chart 1: Historical Levels for 6m Libor
curve over the past few months has renewed 11.00
interest in structured notes. Coupons on some 10.00
6.50% barrier
agency callable daily range accrual notes 9.00 6m Libor
8.00 Fed Funds Target
(CDRANs) have occasionally crossed the 7.0% 7.00
threshold – a sought-after bogey among

Rate (%)
6.00
investors. 5.00
4.00
„ One example is a recently priced agency 3.00

CDRAN – a 7.03% 15nc3m Berm with a 0-6.5% 2.00

range on 6m Libor. Forwards on 6mL project, it 1.00

0.00
won’t exceed 5.00% until 2017; there is currently

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an 80% probability that the bond is called within
the first year. The last time 6mL was above
6.50% was H2 2000, when the Fed lifted the Source: BNP Paribas
target rate from 6.00% to 6.50%.
Chart 2: 6m Libor Forwards vs. 15nc3m RANs
„ STRATEGY: We recommend high coupon
agency CDRANs for sophisticated investors 7.00
looking to increase yield who have tolerance for
6.00
the considerable duration and vega risk
embedded in the structures. Long-end 5.00
Yield (%)

normalized vols have fallen by about 10% over 4.00

the past two weeks, but show evidence of a 3.00
trough. As they climb back up, we think early 7.00% Barrier for 6.40% cpn
6.50% Barrier for 7.03% cpn
March may provide a superb entry point for 2.00
6m Libor forwards
these structures. 1.00 Lower Barrier

0.00
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Playing the range in CDRANs Source: BNP Paribas
The trade-off between coupon and accrual range
among CDRAN structures is fairly straightforward: Chart 3:Call Probs 7.03% 15nc3m 0-6.5% RAN
the narrower the range, the higher the coupon. For 100%
example, a 15nc3m CDRAN can currently have a 90%
6.40% coupon with a 0-7.00% range on 6m Libor, or 80%

a 7.03% coupon with a 0-6.50% range. This 50bp 70%

Probability (%)

60%
difference in the range is significant when you Cumulative Probability Bond is Called
50%
consider the following: 40% Probability Call Exercised on Call Date

30%
ƒ Current forwards project that 6m Libor will rise 20%
gradually then flatten out at ~5.50% over the next 15 10%
years (shown in Chart 2). 0%
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ƒ This 50 bp difference in the upper barrier becomes

Call Date
more significant when you consider the history of 6m
Libor and the target Fed funds rate (shown in Chart Source: BNP Paribas
1) versus the two barriers. When the Fed lifted the
target to 6.50% and held it there throughout H2
2000, 6m Libor set above 6.50% for most of that
period, but only touched 7.00% a few days. In fact,
the last time that 6m Libor set consistently above
7.00% was over 20 years ago – in the late 1980s to
early 1991 – when the Fed pushed the target rate
from 6.00% to 9.75%.

Mary-Beth Fisher 17 February 2011

Market Mover, Non-Objective Research Section www.GlobalMarkets.bnpparibas.com
ƒ Range accrual notes aren’t valued and priced
based on historical levels, but based on projected
forwards and volatility. That being said, it shouldn’t
be surprising that the 50bp increase in the upper end
of the range costs 60+bp in coupon, or that some
investors have preferences for particular range
barriers.
Nontrivial duration and vega risk
As an example of the risks inherent in these kinds of
structured notes, we consider the 7.03% 15nc3m 0-
6.5% CDRAN. This would currently be issued at par.
ƒ The duration of the structure is 0.074%, giving it a
DV01 of USD 742 per USD 1 million face.
ƒ The vega risk is 0.46% for a 10% increase in
normalized vol, or a price decline of USD 4,650 per
USD 1 million notional for a 10% increase in vol.
ƒ Despite the fairly long duration, the bond has an
80% probability of being called in the first year and a
93% chance of being called on during its lifetime
(shown in Chart 3).
Mary-Beth Fisher
Market Mover, Non-Objective Research Section
The long duration for a security that is callable in
three months can at first seem surprising. Although
our model assigns a very low probability to 6m Libor
getting close to or exceeding the 6.5% upper barrier,
if it were to do so the CDRAN would essentially begin
to trade like a zero coupon bond – that is, at a deeply
discounted price. This significantly increases the
duration, despite the high likelihood that it will be
called.
The effect of this on investors’ portfolio is that the
duration and vega risk of the bond is projected to
decline quite quickly, assuming, of course, that the
Fed doesn’t raise rates in the next few months and
the bond is called in its first year. The mark-to-market
risk can be significant though, especially in a high-
volatility, bear-steepening environment when the
rewards of such structures are often greatest. We
encourage investors to evaluate such risks
beforehand, and can provide further analysis and
answer questions as needed.
17 February 2011
www.GlobalMarkets.bnpparibas.com