1. Yields and Bills. 100

(a)  Define the following yield concepts:

• Redemption yield

It is the total return expected from a bond if the bond is held to maturity.

• Par yield

It is the yield at which bond’s stated interest rate is equal to the market interest rate. Par yield is used in determining the fixed interest of securities as well as interest rate swaps.

• Yield to put

It is the yield attributable to a bondholder for holding the bond until it is sold back to the issuer. • Yield to worst

It is the yield that is expected to be received on a bondholder without the issuer defaulting.

(b)  Can a zero and an otherwise identical, maturity-matched level-coupon bond ever have the same duration?

Answer:

The duration of a zero coupon bond equals time to maturity while bonds with a coupon interest will have duration less than maturity. The lower the coupon rate is, the higher the duration of a bond.

(c)  A 3M T-bill currently sells for 98:08 (what does this quotation mean?). Calculate its bond equivalent yield.

Answer:

98:08 means a bid price of 98 and 8/32 or 988/32 which is equal 98.25% (8/32=0.25). This means the bid price is 98.25% of $1,000=$982.50

Bond equivalent yield=(Face value –Price)/ Price x Time

Bond equivalent yield=(1,000-982.50)/982.50 x 365/90

Bond equivalent yield=0.07224 or 7.224%

(d)  Calculate the discount yield of the preceding 3M T-bill currently selling for 98:08.

Discount yield=(Face value –Price)/ Face value x Time

Discount yield=(1,000-982.50)/ 1,000x 365/90

Discount yield=0.07097 or 7.097%

(e)  What does convexity measure and how is it used in the assessment of interest rate risk?

Answer:

Convexity measures the rate of change of a price of a bond in relation to bond yield. That is, it measures the curvature of relationship of the price-yield curve.

It shows how the duration changes with changes in interest rates. The bond duration has a linear relationship with bond prices and interest rates, whereas, the bond prices are inversely related with interest rates (if interest rates increases bond prices decreases). Therefore, if the bond duration is high, the price of the bond will change to greater amounts in the opposite direction of interest rates.

2. Term Structure of Interest Rates. Your investment company’s trading system has become unstable after a recent update so that your superiors ask you to verify the calculations displayed on the traders’ screens.

(a) Using current UST security information from Bloomberg reproduced above, you extract the relevant spot rates by hand and fill in the remainder of the table to verify the computations of your system. Note that the maturities are exactly as stated. You might want to provide the requisite formulae indicating your exact calculations to convince your boss that it is not you who is at fault but rather the IT techs who botched the update.

Answer:

Spot yield =[(FV/Mp)1/nxm-1]/x m

Discount yield = [(FV – Mp)/FV] x [360/m]

Forward rate=[(1+rn2/2)t2 ] / [(1+rn1/2)t1]-1

UST Bill:

Spot yield =(100/99.965)1/0.5-1] x 2 x100%=0.14%

Discount factor =(100-99.965)/100 x 360/182=0.07

UST -Strip:

Spot yield =(100/99.900)1/1-1] x 1 x100%=0.10%

Discount factor =(100-99.900)/100 x100%=0.10%

Forward rate=[(1+0.001)2 ]/ [(1+0.0014)1]-1 x 100%=0.06%

UST -Note:

Spot yield =(100/100.1403)-2×2-1] x 2 x100%=1.12%

Discount factor =(100.0152-100)/100 x100%=0.015%

Forward rate=[(1+0.07 ]2/ [(1+0.001)]-1 x 100%=0.14%

UST -Note:

Spot yield =(100/100.0152)-1.5×2-1] x 1.5 x100%=0.07%

Discount factor =(100. 1403-100)/100 x100%=0.014%

Forward rate=[(1+0.0112 ]2/ [(1+0.07)]-1 x 100%=

(b) Draw the corresponding UST discount yield curve and indicate a hypothetical AAA corporate term structure (sketch) relative to the US TSIR.

Maturity (Years)

The Horizontal axis represents Maturity(Years) while the vertical axis represents Yield (%).

The yellow line-Inverted curve

Green line-Normal curve

Blue line-Flat line

(c) What is the relationship between the US sovereign and corporate AAA yield curves? What explains the difference in yields by maturity and how do markets use this information?

Answer:

The relationship between the US sovereign and corporate AAA yield curves is that the yields for corporate AAA are usually based on the US sovereign yields. The yield curve shows the relationship of different yield for different instruments with different to maturities. Since the yield curves shows the relationship between interest rates in the short term and long term interest rates, it can be used to determine zero coupon bonds.

(d) The FRB has announced in December 2016 that it will cease to intervene in bond markets and bring its policy of quantitative easing to an end. What will the effect of the Fed’s tapering announcement on the yield curve be? Explain

Answer:

The announcement by FRB to bring its policy of quantitative easing to an end will result in increasing interest rates in the bond market causing the yield curve to slope downwards (inverted shape).

(e) Optional. Research the current yield curve (as of the date of the exam)and compare it to the one at the beginning of the year. What do you see? Download the data (e.g., www.treasury.gov), generate the requisite chart, and explain.

3. Interest-Rate Risk Management. As chief financial officer (CFO) of TSTR (“Too Small To Rescue”) Bank, a small neighborhood bank, one of your primary tasks is the management of its interest rate exposure. You are currently trying to convince your board, composed of neighborhood worthies, to measure and manage your institution’s interest rate risk by using mathematical relations between fixed-income prices and yields.

(a)  State a formula which relates changes in fixed-income price to interest-rate variability (i.e., changes in yields) using at least one if not two different measures of yield sensitivity. Illustrate how bond prices are related to yields on the basis of this formula and a diagram. Why or why not is this approach valid?

Answer:

The formula that relates the changes in fixed-income price to interest-rate variability is Macaulay’s duration formula;

Macaulay’s duration = ∑t1 x[CFt / (1 + y)t]/Po

Where:

· ∑-Sum of Present values of all cash flows of the bond

· t1-Period of the cash flows

· [CFt / (1 + y)t]- Present values of all cash flows at time t

· y-Yield to maturity

· Po-Price of the Bond

Since Macaulay’s duration formula is measured in years, therefore, the change in fixed income prices in relation to changes in yield determined by comparing the durations of different bonds. However Macaulay’s duration does not effectively measure yield sensitivity, thus, modified duration is determined as follows;

Modified duration= Macaulay’s duration/(1+y/n)

Where;

· y-Yield to maturity

· n-number of periodic payments

(b)  The modified duration and convexity of a high-grade corporate bond in TSTR’s investment portfolio are 5.6 years and 34.9, respectively. By what dollar amounts would you expect its price to change for a 60 bpts rise or fall in interest rates given that the current bond’s price is $91.65?

Change in Bond Price = (Change in Yield × Modified Duration) + ½(convexity x Change in Yield)

Change in Bond Price =-(60% x 5.6) +½(34.9 x 60%)

Change in Bond Price =-(3.36+10.470

Change in Bond Price =-13.83%

If the interest rates rises by 60 bpts, the bond price decreases by 13.83% . If the interest rates decreases by 60 bpts, the bond price increases by 13.83% .

Change in Bond Price (Dollar amounts) =13.83% x$91.65

Change in Bond Price (Dollar amounts) =(+/-) $12.68

(c)  At a meeting of TSTR Bank’s board you propose to change current A&L management practices focusing more on interest-rate risk.

• Formulate an appropriate objective in terms of a measure of interest-rate sensitivity.

• One of your board members, a retired S&L executive, claims that your approach to interest-rate exposure measurement and management is fundamentally flawed.

What problems might she referring to? Do you agree with her assessment?

Answer

Modified duration assumes that the bond price changes in equal amount with the changes in bond yield that is why convexity adjustment is needed. However, the measurement of interest-rate risk in relation to the overall structure of the yield curve is not possible. Thus, Effective duration should be used instead of a modified duration. Effective duration takes into consideration expected fluctuations in the bond prices by measuring the changes in bond prices in relation to the yield curve.

Effective duration=[Vo(-)+Vo(+)]/ [2x Δ Yield curve x Vo]

Where;

· Vo(-) is present value of a bond price if the Bond price decreases

· Vo(+)-is present value of a bond price if the Bond price increases

· Vo-is the present value of bond prices

· Δ Yield curve-Change in yield curve

However, the problem of the interest-rate exposure measurement is that it only determines the approximate effect of interest rate changes on prices, but cannot be used to forecast interest rates.

(d)  Currently, the average duration of your loan portfolio is 3 years whereas the average du- ration of your various fixed income liabilities (deposits and bonds) is 1.5 years. Propose a strategy to neutralize the effect of interest-rate changes on your balance sheet which is (in million USD) as follows:

Answer

The portfolio management strategy to neutralize the effect of interest-rate changes on your balance sheet is the immunization strategy. Portfolio Immunization strategy will be used to minimize the interest rate risk of bonds by adjusting loan portfolio duration to match the investment’s period. Immunization is done by acquiring either a zero-coupon bond that has the same maturity period with the portfolio, a number of coupon bonds each with the same maturity period as the portfolio or several bonds with an average duration equal to the portfolio duration.

Since the average duration of the fixed income liabilities (deposits and bonds) of 1.5 years (1.5 x 2) is equal to loan portfolio duration of 3 years, the assets and liabilities are immunized.

4. Commercial Banking. You are a corporate account officer with TLTF (“Too Large To Fail”) Bank. One of your major clients just sold a piece of customized machinery to be delivered in one year’s time. The company’s CFO inquiries about the possibilities of investing USD 10 m in a year from now for one year.

(a) What kind of investment opportunity (contract) would you suggest to them?

Answer

Futures contract- They are contracts made today to buy or sell an asset in the future. I suggest the company to enter into a futures contract because they are standardized and are traded on an exchange market thereby reducing the possibility of default.

(b)  Currently, 1-year and 2-year spot rates are 6.50% and 7.25%, respectively. Quote a return for the preceding investment suggestion. Since your customer is of a somewhat suspicious nature you need to indicate the formula used to derive the quote.

Answer

The formula used to derive the quote is:

Spot rate=[FV/Mp)1/nxm-1]/x m

Formula for the quote;

(1+ fn3/2)(t2-t1)= [(1+rn2/2)t2 ] / [(1+rn1/2)t1]

fn3/2)(t2-t1)= (1+rn2/2)t2 ] / [(1+rn1/2)t1]-1

Where;

· FV-Fave value

· Mp – Current Market price

· n-years

· m-Number of periods

· fn3 –Rate for year 3

· rn2 and rn1-Rates for years 2 and 1 respectively.

(1+ fn3/2)1=(1+0.0725/2)2 /(1+0.065/2)1

(1+ fn3/2)1=(1.0363)2 /(1.0325)1

(1+ fn3/2)1=1.0739/1.0325

fn3/2)1=(1.0739/1.0325)-1

fn3=0.0401 x 2

fn3=0.0802

The quote= 0.0802 x 100%=8.02%

(c) What alternative investments could you suggest to your customer?

Answer

The Forward contracts- They are contracts made today to buy or sell an asset in the future. They are similar to futures contracts. However, they are not traded on the exchange markets.

Swap contracts-These are contracts that allow the parties to exchange cash flows arising from an underlying asset. They are also applicable where the companies in the market have different credit ratings or borrowing strengths. A company with a poor credit rating will borrow at a fixed interest rate in anticipation of a decline in future interest rates. A company with a good credit rating will borrow at a flexible interest rate in anticipation of an increase in future interest rates.

d)  Define the forward curve. Why or why not is it a good predictor of future interest rates?

A forward curve is a graphical representation of the relationship between the price of a forward contract and the period maturity of that forward contract. Forward curve is a good predictor of future interest rates because it usually contains information that reflects the market expectations and the risk premium. It is also a good predictor of returns between investments. However, it is not easy to accurately anticipate the forward interest rates because of the future uncertainties.

5. Funding Positions. As a junior trader at your investment bank, you quickly and cost-effectively need to fund overnight a $100m position in the on-the-run 5Y UST note. On Feb 17, 2014, this note, which pays a 3% coupon and matures on 03/21/2019, is quoted at a bid-ask of 100 21/32-22/32 (careful: what does the quote convention mean?).

(a)  What should the invoice price of this note be? In your computation of accrued interest, please note that February is an odd month.

Answer

Bid price = 100 21/32), 100.6563% of $100 =$100.6563m –Willing to be sold at $100.6563m

Ask price =( (100 22/32) ,100.6875% of $100 =$100.6875m- Willing to be bought at $100.6875m

Invoice price= Bid price + Accrued interest

Accrued interest=(Annual interest/2) x (Days in the interest period/Days Separating the dates for interest payment)

Annual interest=3% x $100.6563m/=$1.5198m

Accrued interest=$1.5198m x 48/183

Accrued interest=$0.3986m

Invoice price=$100.6563m +$0.3986m

Invoice price=$101.0549m or $101,054,900

(b)  The general-collateral repo rates rates are 1.10%-1.25% (dealer pays-earns interest) on 02/17/14. If the market required a 2% margin, how much of the purchase price could you have borrowed in the repo market, and how much interest would you have paid for a one-day loan? What would have your equity stake in the position be?

Answer

Market Value of the Loan=$100, 656,300

Purchase price=$100, 656,300-(2% x $100, 656,300)

Purchase price=$100, 656,300-$2,013,126

Purchase price=$98,643,174

Repo Interest=1.10% x $100, 656,300 x 1/360=$3,076

The Equity stake=$100, 656,300+$3,076

The Equity stake=$100, 659,376

(C)At the expiration of the 1D repo (next day), the bond is trading at 100 22/32-23/32 (careful: what does the quote convention mean?). What is your total profit or loss if you were to close out your position?

Bid price = (100 22/32), 100. 6875% of $100 =$100. 6875m – Willing to be sold at $100. 6875m

Bid price= $100,687,500

Ask price =(100 23/32) ,100.71875% of $100 =$100.7187 5m- Willing to be bought at $100.7187 5m

Profit or loss=$100, 659,376-$100,687,500

Loss=-$28,124

(d)  As an alternative, you consider an overnight loan in the fed funds market. What are fed funds rates and how do they relate to repo rates? Explain.

Answer

The fed funds rates are the interest rates at which commercial banks lend funds overnight to other banks. The federal funds rates basis of other interest rates and is usually higher than the repo rate. This is because federal funds borrowings have no collateral thus, unsecured. Federal funds borrowings simply depend on the creditworthiness of the bank.

(e)  Optional. What are ‘fails’ in the repo market? Describe two strategies to take advantage of fails and to what purpose unscrupulous market participants would use them.

Answer

In the repo market the seller may fail to repurchase the security at the maturity date which may result in the buyer selling the security to another party in an effort to recover the amount paid for the security. Also the value of the security may decline thus, the buyer holding on the security or to sell it at a loss. The buyer may also not sell the security back if the value of the security rises above the normal terms agreed-upon.

6. Swap Valuation. The date is January 3, 2019 and you just returned to work from a thorough and exhausting celebration of the New Year. As a junior clerk on the USD fixed- income derivative desk your first transaction of the year involves a 5Y fixed-for-floating swap with yearly payments on $100m notional. Bloomberg provides you with the following data:

(a)  In terms of cash-replication, the above 5Y plain vanilla swap corresponds to holding what positions in what type of instruments?

Answer:

The above 5Y plain vanilla swap corresponds to of forward rate contracts. One party agrees to pay a fixed rate of interest on the notional principal on specified dates for a specific period of time and the other party agrees to make payments based on the floating interest rate to the first party on the notional principal. The floating interest rates are commonly based on the LIBOR (London Interbank Offer Rate).

(b)  How much is the swap worth at inception?

Answer:

The swap worth at inception=$0

At inception, the value of a swap is zero. The value of a swap is always its market value.

(c) Calculate the 5Y swap rate for an annual fixed-for-floating USD swap. What is an appropriate bid-ask spread assuming that the Bloomberg data are midpoints?

Swap rate=Present value Floating rate payments/ Present value Notional principal

(d) You ponder various strategies to hedge the resulting interest-rate exposure. Describe two different strategies which you could use to hedge the transaction.

Answer:

To hedge against the interest rate exposure, we can use

i). The forward contracts- This strategy will allow us to enter into a contract with the lender to borrow a given amount of money at an agreed future interest rate. In this case, we will (borrower) gain if the rate at the time of borrowing is higher than the agreed upon interest rate.

ii). Interest rate Swaps- This strategy will allows us to exploit different interest rates in different markets borrowing and thereby altering or reducing the payment of interest payments.

(e)  Optional. Your company has sold a 6Y plain-vanilla swap on 1Y LIBOR precisely one 20 year ago for a swap rate of 7.15%; as a consequence, you receive fixed and pay floating. What value should your accounting system attribute to the swap today (notional principal: $40m)?

7. Treasury Inflation-Protected Securities. Since 1997, the US Treasury has provided inflation insurance to interested parties through its TIPS program. TreasuryDirect explains:

“Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases. The relationship between TIPS and the Consumer Price Index affects both the sum you are paid when your TIPS matures and the amount of interest that a TIPS pays you every six months. TIPS pay interest at a fixed rate. Because the rate is applied to the adjusted principal, however, interest payments can vary in amount from one period to the next. If inflation occurs, the interest payment increases. In the event of deflation, the interest payment decreases. At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation…. TIPS are issued in terms of 5 (auction dates: April, *August, *December), 10 (January, *March, *May, July, *September, *November), and 30 (February, *June, *October) years” (* denotes a reopening, in which the US Treasury sell an additional amount of a previously issued security; www.treasurydirect.gov/indiv/research/indepth/tips/res tips.htm).

You might also want to refer to the attached analyst report by HIMCO (May 2014), The Case for Treasury Inflation-Protected Securities.

(a) What is the rationale to invest in a TIPS? Does it still hold?

Answer

The rationale for investment in TIPS is that it shields the investors from the effect of inflation. Since the principal amount is adjusted to reflect the inflation, interest payments received on the investment is usually higher. TIPS can also be used by investors to defer the tax liability and investors receive the full amount invested on their maturity.

However, TIPS offer investors a lower interest income and results in high tax burden to the investors because of the high interest received.

(b) Consider a normal UST security and and otherwise completely equivalent TIPS. Which one should carry a higher yield, the TIPS or the nominal UST security? Explain.

Answer

The nominal UST security will carry the higher yield compared to the TIPS investment. However, if inflation increases, the principal on the TIPS will be adjusted to incorporate the rise of inflation resulting in higher coupon payments to rise while the principle amount for UST security will remain constant. However, the benefit on TIPS is mostly realized on maturity, thus, investment the nominal UST security will still be better in the short term. In case of deflation, UST will still yield more than the TIPS since the principal amount would be reduced to reflect the deflation under TIPS, thus decreasing the coupon payments.

(c) Can the yield (to maturity) of a TIPS ever become negative? Why or why not? Explain.

Answer.

Yes. The yield (to maturity) of TIPS can become negative and it occurs where the securities are trading at a rate that is lower than the inflation rate. This is because the securities yield is usually adjusted by deducting the expected inflation rate.

(d) How much have investors apparently been willing to pay for this privilege recently? You might want to consult recent US Treasury auction results carefully documenting your information source and data.

https://www.treasurydirect.gov/instit/annceresult/tipscpi/tipscpi.htm

(e)  Optional. In 2004, the US Treasury issued the following 10Y TIPS maturing in July 2014:

Suppose that this security were to trade at a bid-ask price of 102-04/05+ (careful: what does the quote convention mean?) with a coupon rate of 2.0%. Given the reference CPI data below, what should the index ratio be on Feb 7, 2014? What is the accrued interest on this security as of Feb 7, 2014? What is its invoice price?

Index ratio= 233.0647/233.0654=1.0025

Accrued interest=(Annual interest/2) x (Days in the interest period/Days Separating the dates for interest payment)

Bid price=102-0.4=$101.6

Annual interest=2% x $101.6/=$2.032

Accrued interest=$1.96/2 x 38/182 (Semiannual Coupon payment)

Accrued interest=$0.212

Invoice price= $101.6 +$0.212

Invoice price= $101.812

8. Corporates, M&A, and Callability. As a member of bond origination team, you have been working on a transaction on behalf of CVS Health Corp. (NSE: CVS) which had been planning a massive bond offering to fund the acquisition of Aetna Inc (NSE: AET). You are in charge of all the fixed-income analysis and report directly to the lead banker. A lot is on the line for your company because this deal might become the largest bond offering in 2018.

In addition to the below recent press coverage of the bond issue, you might want to consult the attached extract from the Offering Circular.

CVS Health completes world’s third-largest corporate bond sale: US pharmacy chain raises $40bn to fund purchase of health insurer Aetna

CVS Health completed the third-largest corporate bond sale in history on Tuesday, underlining the market’s ability to absorb sizeable debt issuance at the right price, despite a backdrop of rising interest rates and regulatory uncertainty. The pharmacy chain’s $40bn sale — to fund its proposed acquisition of health insurer Aetna — attracted $120.7bn of orders, according to four people with knowledge of the sale. Investors said the debt’s reasonable pricing supported the record demand, and advance notice from underwriters gave fund managers the chance to set aside cash for the offering.

Bankers and investors said the sale suggested the US bond market was comfortable with two key risks: rising yields on global government debt, and uncertainty about regulators’ approach to so-called vertical mergers, or tie-ups between companies that are not direct competitors.

CVS sold nine bonds across seven maturities to fund the deal. Most of the securities face a mandatory redemption if the acquisition is not completed by mid-2019, according to Moody’s, which assigned the debt a Baa1 rating.

Investors submitted more than $110bn of orders for $46bn of bonds issued by Anheuser-Busch InBev to fund its acquisition of SABMiller, and $101bn for the $49bn of bonds issued to fund Verizon’s acquisition of Verizon Wireless.

Spreads between yields of the new securities and benchmark government debt were mostly similar or wider than spreads offered in other large bond sales. The new five-year CVS bonds were sold at a yield of 3.899 per cent, a spread of 125 basis points over Treasuries. To compare, five-year spreads were 120 basis points in the Anheuser-Busch InBev deal. CVS’s new 10- year bonds were sold at a yield of 4.475 per cent, 160 basis points higher than benchmark Treasuries, giving them the same spread as the Anheuser-Busch deal.

Some commentators have questioned the market’s resilience — investor Bill Gross, for ex- ample, in January predicted the start of a bear market in bonds. Spreads widened for the corporate debt market as a whole in February, according to ICE Bank of America Merrill Lynch indices. “We anticipate an uptick in M&A activity, so the success of today’s transaction is important to show the marketplace there is still plenty of liquidity,” said Dan Mead, head of the US investment-grade syndicate desk at BofAML.

Some bond tenors were offered with steeper-than-normal price discounts, which investors said was to compensate for the risk that regulators may block the deal. The Justice Department’s challenge to the tie-up between AT&T and Time Warner has fuelled uncertainty about the CVS-Aetna deal. However, bullishness about the prospects of the combined company fed demand for the bonds. (FT, March 06, 2016)

(a)  Analyze CVS, Aetna, and the terms of the CVS offering.

• How well have CVS and Aetna been doing? What is the financing for? • What exactly is on offer? How do the tranches differ? Present the terms of the various series in table format. • What other debt is CVS taking on and how is it structured?

Answer:

CVS Health and Aetna’s’ review exhibits better performance. CVS Health is the only integrated pharmacy healthcare company with a large market share as indicated by its numerous retail outlets and walk-in clinics in various locations. Also, it being the only integrated pharmacy healthcare company is an indicator that CVS health has a strong financial strength compared to its competitors in the industry. It has quality manpower that is why it is able to provide various innovative products and services to its customers. On the other hand, Aetna seems to have been struggling financially despite being the nation’s leading healthcare benefits company as shown by the company disposing of a number of its operations.

CVS Health is seeking funds to finance the cash portion of purchase price of the merger. CVS is offering bond amounting to $40,000,000,000 however, the actual net proceeds from the offering that will be received by CVS Health are expected to be $39,393,930,000. This amount is after deducting the underwriting discount and the expected offering expenses.

It is also taking on other borrowings under their existing term loan facility terms that will approximately be $7.9 billion

Bonds Bond offering Coupon rate Offering price Maturity date Redemption date
2020 Floating rate Notes $ 1,000,000,000 Floating $ 1,000,000,000 9-Mar-20  None
2021 Floating rate Notes $ 1,000,000,000 Floating $ 1,000,000,000 9-Mar-21  None
2020 Notes $ 2,000,000,000 3.125% $ 1,999,040,000 9-Mar-20  Any time
2021 Notes $ 3,000,000,000 3.350% $ 2,998,470,000 9-Mar-21  Any time
2023 Notes $ 6,000,000,000 3.700% $ 5,946,240,000 9-Mar-23 9-Feb-23
2025 Notes $ 5,000,000,000 4.100% $ 4,951,050,000 9-Mar-25 25-Jan-25
2028 Notes $ 9,000,000,000 4.300% $ 8,873,460,000 9-Mar-28 25-Dec-27
2038 Notes $ 5,000,000,000 4.780% $ 4,900,700,000 9-Mar-38 25-Sep-37
2048 Notes $ 8,000,000,000 5.050% $ 7,954,400,000 9-Mar-48 25-Sep-47

(b)  Are the various tranches callable? If so, when and why? How does callability differ in this case from regular corporate callables? What are CVS trying to accomplish and what is unusual about the series’ callability?

Some of the tranches are callable: 2023 Notes on February 25, 2023; 2025 Notes on January 25, 2025; 2028 Notes on December 25, 2027; 2038 Notes on September 25, 2037 and 2048 Notes on September 25, 2047.

Callability is the possibility of the bond being redeemed before the maturity date. Under the regular corporate bonds, bonds are callable on the basis of terms stated at the discretion of the issuer which may not necessarily be subject to an event happening. CVS’s bonds differ from the regular corporate bonds because they are subject to an event happening. That is, they are conditioned on the consummation of the merger.

(c)  Using the attached information or any other data, whose source you would have to carefully document, critically review the pricing and terms of the debt.

• How were the bonds rated? How did the deal change CVS’ perceived credit risk and how does it influence the pricing of the bonds?

• What yields would you propose for the nine series? How should they vary with the terms of the individual tranches?

• How do price and proceeds diverge?

Answer:

These bonds have been rated at a price lower than their face value (Bond offering) apart from the Floating rate notes. The issue of bonds at price lower than the Bond offering (Face value), is said to be issuing the bond at a discount. This could have been done on the perception that the market interest rates would be higher than the stated interest rates. Thus, CVS Health not expected to incur higher interest rate expenses. However, the will be required to pay higher maturity value when they mature because they will be paying the bondholders the face value of these bonds.

Therefore, the two Floating rate notes should remain the same while the remaining should have Yield higher than the stated rates.

The price and the proceeds diverge because of the offering expenses and underwriting expenses.

(d) Research the issue and try to find out what happened. Did the final offering differ from the initial announcement and, if so, why?

Answer:

The final offering differed from the initial announcement because of the many orders it received on the issue that exceeded the $40 billion expectation.


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