Payment-In-Kind (PIK) facilities have virtual interest payments that increase the principal amount of the loan. Interest is cleared similarly to a standard bank loan, but interest is wiped off once the contract matures, and the position is increased by the amount of accrued interest.

The coupon interest rate is typically a floating spread above an index, such as LIBOR. The spread varies with the term of the loan, the credit rating of the borrower, and other factors. There are also fixed rate loans. For both floating and fixed rate loans, interest is charged on the funded portion of revolving loans, and a nominal facility fee (75 to 150 basis points) is charged for the unfunded portion.

A pro-rata tranche is a portion of a syndicated bank loan that is made up of a revolving credit facility and an amortizing term loan, and it is syndicated by banks.  Institutional tranches have the same components at pro-rata tranches, but are syndicated primarily by non-bank lending institutions, such as prime brokers. Both tranches may often be found within the same syndicated loan.  Within a pro-rata tranche, the revolving credit line will typically have the same ending or maturity date as the term loan. By forming a syndicate, banks involved in the deal can spread the credit risks among several lenders. Pro-rata tranches have historically been much larger than institutional tranches in terms of dollar size.

Bank debt often settles on a delayed basis (delayed compensation). For instance, a pro-forma settlement period of 7 days may actually be delayed to 30 days. During the 23 day interim, the borrower is obligated to make the lenders whole with regard to interest accruals. Standard settlements in the U.S. under the LSTA are trade date + 7 and settlements under the European LMA are trade date + 10

Cash trades are ones in which the lender pays out the entire notional amount of the loan in exchange for the full-paid note. Swap trades are total return swaps in which the lender enters into a swap with another counterparty which has purchased the loan and subsequently writes the swap. The counterparty holds the loan, and swap payments are made on a monthly basis. The counterparty charges a swap fee to the lender.

There are several types of fees associated with bank debt:

• Arrangement fee – received by arranger/agent in return for putting deal together
• Underwriting fee – price paid by borrower for commitment to obtain financing during syndication
• Participation fee – received by syndicate participants
• Facility fee – payable to banks in return for providing facility whether used or not
• Commitment fee – paid for unused portion of facility to compensate lender for tying up the capital
• Agency fee – payment for agent bank’s services
• Prepayment fee – penalty assessed to borrower for prepayment
• Transfer fee – fee charged by agent bank for transferring a portion of a loan from one lender of record to another lender of record

Related posts:

1. Coupon Interest on Syndicated Bank Debt – Part One
2. Coupon Interest on Mortgage-Backed Securities Part 1 – Pass-Throughs
3. Coupon Interest on Mortgage-Backed Securities 2 – CMOs and Strips

Repos provide leverage: Hedge Fund H gets the use of a security without having to expend the purchase price of the security. Instead, Hedge Fund H is charged repo interest on the cash borrowed from Prime Broker B, which is offset by the coupon interest Hedge Fund H earns on the security; the difference is the carry on the trade (cost of keeping the position on). Thus, Hedge Fund H is able to finance many more securities this way as compared to outright purchase.

First Monday

On Monday, Hedge Fund H purchases $1M face of 10-year Treasury note with a 6% coupon at a price of 101 from Broker M in the cash market. There is $20,000 accrued interest in the note as of Tuesday, for which Hedge Fund H must pay.  The settle date for the purchase is Tuesday (i.e. it is regular settle; cash settle would occur on Monday).  On Tuesday, Broker M  delivers the Treasury  Notes to Hedge Fund H’s custodian, Prime Broker B,  and Hedge Fund H wires $1,030,000 ($1M face * 1.01 + 20,000)  to Broker M.

First Tuesday

On Tuesday, Hedge Fund H also enters into a 1-week term repo transaction with Broker S for $1M of the same Treasury Note, which is now priced (on Tuesday) at 101.5. The repo interest rate on collateral is 5%. The full price of the note (that is, including accrued interest) is 103.5. Broker S charges a 2% haircut on the Treasury note.  Hedge Fund H delivers the $1M par of Treasury notes to Broker S on Tuesday.  Broker S pays Hedge Fund H ($1,035,000 full price / 1.02% haircut) = $1,014,706 proceeds.   (In reality, the price is usually rounded. In this case, it would probably be rounded to $1,015,000).

Note that Hedge Fund H paid out $1,030,000 for the purchase of the security, and received in $1,014,706 by repo’ing the security. Thus, Hedge Fund H’s net cash flow is -$15,294 on the first Tuesday. This reflects both the haircut and the price movement of the security.

Second Tuesday

For the one week period (Tuesday to Tuesday), Hedge Fund H accrued 7 days of coupon interest at 6% annual on $1M = (7/182) * ($1M) * (.03) = $1,153. The note is currently carrying $20,000 + $1,153 = $21,153 accrued interest.

The current price of the Treasury note has risen to 103 over the last week. Hedge Fund H sells the Treasury note to a counterparty for $1,030,000 + $21,153 = $1,051,154.

On the same day, Hedge Fund H receives its $1M par Treasury Notes back from Broker S. No coupon was paid during the period. Hedge Fund H calculates the repo fee to Broker S as 5% on the $1,014,706 proceeds for 7 days = (7/360) * ($1,014,706) * (.05) = $986.  This repo fee plus the original proceeds of  $1,014,706 sums to $1,015,692, which is the amount Hedge Fund H wires to Broker S.

Note that Hedge Fund H paid out $1,015,692 when terminating the repo, and received $1,051,154 for selling the note, giving Hedge Fund H a positive cash flow of $35,462 on the second Tuesday. When this cash flow is netted against the cash flow from the previous Tuesday of -$15,294, the total profit from the transaction is calculated to be $20,167.

The gain or loss on the buy and sell of securities, calculated on a FIFO-lot basis, plus the interest income earned, less the interest expense incurred, represents the total profit from security trading. Repos and reverse repos are simply methods to finance security trades.

Related posts:

1. Position Groups Enhance P&L Reporting
2. Securities-Lending Risks
3. Resequencing Tax Lots