MEDIUM TERM NOTES (MTNs) – AIGI CAPITAL/LoanS LIMITED

EURO-MTNS

MTNs have become a major source of financing in international financial markets, particularly in the Euro-market. Like Euro-bonds, Euro-MTNs are not subject to national regulations, such as registration requirements. Although Euro-MTNs and Euro-bonds can be sold throughout the world, the major underwriters and dealers are located in London, where most offerings are distributed.

Although the first Euro-MTN program was established in 1986, the market represented a minor source of financing throughout the 1980s. In the 1990s, the Euro-MTN market has grown at a phenomenal rate, with outstandings increasing from less than $10 billion in early 1990 to $68 billion in May 1993 (chart 5). New borrowers account for most of this growth, as a majority of the 190 entities that have established Euro-MTN programs did so in the 1990s. As in the U.S. market, flexibility is the driving force behind the rapid growth of the Euro-MTN market. Under a single documentation framework, an issuer with a Euro-MTN program has great flexibility in the size, currency denomination, and structure of offerings. Furthermore, reverse inquiry gives issuers of Euro-MTNs the opportunity to reduce funding costs by responding to investor preferences.

The characteristics of Euro-MTNs are similar, but not identical, to MTNs issued in the U.S. market. In both markets, most MTNs are issued with investment-grade credit ratings, but the ratings on Euro-MTNs tend to be higher. In 1992, for example, 68 percent of Euro-MTNs had Aaa or Aa ratings, compared with 13 percent of U.S. corporate MTNs. In both markets, most offerings have maturities of one to five years. However, offerings with maturities longer than ten years account for a smaller percentage of the Euro-market than of the U.S. market. In both markets, dealers have committed to provide liquidity in the secondary market, but by most accounts the Euro-market is less liquid.

In many ways, the Euro-MTN market is more diverse than the U.S. market. For example, the range of currency denominations of Euro-MTNs is broader, as would be expected. The Euro-market also accommodates a broader cross-section of borrowers, both in terms of the country of origin and the type of borrower, which includes sovereign countries, supranational institutions, financial institutions, and industrial companies. Similarly, Euro-MTNs have a more diverse investor base, but the market is not as deep as the U.S. market.

In several respects, the evolution of the Euro-MTN market has paralleled that of the U.S. market. Two of the more important developments have been the growth of structured Euro-MTNs and the emergence of large, discrete offerings. Structured transactions represent 50 percent to 60 percent of EURO-MTN issues, compared with 20 percent to 30 percent in the U.S. market. In the Euro-MTN market, many of the structured transactions involve a currency swap in which the borrower issues an MTN that pays interest and principal in one currency and simultaneously agrees to a swap contract that transforms required cash flows to another currency. Most structured Euro-MTNs arise from investor demand for debt instruments that are otherwise unavailable in the public markets. To be able to respond to investor driven structured transactions, issuers typically build flexibility into their Euro-MTN programs. Most programs allow for issuance of MTNs with unusual interest payments in a broad spectrum of currencies and with a variety of options.

Large, discrete offerings of Euro-MTNs first appeared in 1991, and about forty of these offerings occurred in 1992. They are similar to Euro-bonds in that they are underwritten and are often syndicated using the fixed-price reoffering method. As a result of this development, the distinction between Euro-bonds and Euro-MTNs has blurred, just as the distinctions between corporate bonds and MTNs has blurred in the U.S. market.

The easing of regulatory restrictions by foreign central banks has played an important role in the growth of the Euro-MTN market. For example, over the past year MTNs denominated in deutsche marks have emerged as a major sector in the Euro-market as a result of regulatory changes made by the Bundesbank in August 1992. Under the previous rules, foreign borrowers could only issue debt denominated in deutsche marks through German subsidiaries or other German financial firms, and maturities could not be shorter than two years. Debt denominated in deutsche marks also had to be listed on a German exchange, and these offerings were subject to German law, clearing, and payment procedures. These rules effectively precluded issuers from establishing multicurrency Euro-MTN programs with a deutsche mark option.

In the August 1992 deregulation, the Bundesbank removed the minimum maturity requirement on debt denominated in deutsche marks issued by foreign nonbanks, and it eliminated or simplified issuance procedures for all issuers. Although the new rules require that a “German bank” act as an arranger or dealer, the definition is broad enough to include German branches and subsidiaries of foreign banks. The arranger is required to notify the Bundesbank monthly of the volume and frequency of issues denominated in deutsche marks. As a result of the Bundesbank’s deregulation, from 1991 to 1992, the share of Euro-MTN offerings denominated in deutsche marks increased from 1.4 percent to 4.8 percent, while the volume of issuance in deutsche marks rose from $268 million to $1.69 billion. Other central banks have instituted similar liberalizations that may result in rapid growth of MTNs denominated in other currencies, such as the Swiss franc and the French franc.

OUTLOOK FOR THE MTN MARKET

Few innovations in finance have been as successful as the medium-term note. Its success derives from its remarkable adaptability to the needs of both borrowers and investors. The success can be measured by the number of borrowers, the diversity of note structures, and the amount of outstanding MTNs, all of which have increased dramatically over the past decade.

The adoption of SEC Rule 415 in 1982 was the key event that removed the regulatory impediments to continuous offerings of corporate notes. Other regulatory changes, such as SEC Rule 144A and liberalizations by European central banks, have been instrumental in the development of new sectors in the MTN market. As a result of these regulatory changes, financial markets have become more efficient. In 1992, the SEC eased restrictions on the types of securities eligible for shelf registration. As a result of this ruling, asset-backed MTNs may emerge as the next major growth sector in the public MTN market.

The Federal Reserve Board conducts a survey of borrowing by U.S. corporations in the public MTN market, the largest sector of the worldwide market. The Federal Reserve collects these data to improve its estimates of new securities issues of U.S. corporations, as published in the Federal Reserve Bulletin, and to improve estimates of corporate securities outstanding, as shown in the flow of funds accounts. Material in this and the next two sections was originally presented in “Corporate Medium-Term Notes,” Leland Crabbe, The Continental Bank Journal of Applied Corporate Finance, vol. 4 (Winter 1992), pp. 90-102. For example, MTNs have been callable, putable, and extendible; they have had zero coupons, step-down or step-up coupons, or inverse floating rates; and they have been foreign currency denominated or indexed, and commodity indexed. The most common indexes for floating-rate MTNs are the following: the London interbank offered rate (LIBOR), commercial paper, Treasury bills, federal funds, and the prime rate. MTN programs typically give the issuer the option of making floating-rate interest payments monthly, quarterly, or semiannually. SEC-registered MTNs have the broadest market because they have no resale or transfer restrictions and generally fit within an investor’s investment guidelines. Financing strategies vary among the borrowers. Some corporate treasurers prefer to “go in for size” on one day with financings in the $50 million to $100 million range, reasoning that smaller offerings are more time consuming. Furthermore, a firm may be able to maintain a “scarcity value” for its debt by financing intermittently with large offerings, rather than continuously with small offerings. Other treasurers prefer to raise $50 million to $100 million over the course of several days with $2 million to $10 million draw downs. These corporate treasurers argue that a daily draw down of $50 million is an indication that they should have posted a lower offering rate. In regard to the posting of offering rates, some treasurers post an absolute yield, while others post a spread over Treasuries, usually with a cap on the absolute yield. A few active borrowers typically post rates daily in several maturity sectors; less active borrowers post only in the maturity sector in which they seek financing and suspend postings when they do not require funds. Apart from the distribution process, MTNs have several less significant features that distinguish them from underwritten corporate bonds. First, MTNs are typically sold at par, while traditional under writings are frequently sold at slight discounts or premiums to par. Second, the settlement for MTNs is in same-day funds, whereas corporate bonds generally settle in next-day funds. Although MTNs with long maturities typically settle five business days after the trade date (as is the convention in the corporate bond market), MTNs with short maturities sometimes have a shorter settlement period.

Finally, semiannual interest payments to note holders are typically made on a fixed cycle without regard to the offering date of the maturity date of the MTN; in contrast, corporate bonds typically pay interest on the first or fifteenth day of the month at six-month and annual intervals from the date of the offering. The interest payment convention in the MTN market usually results in a short or a long first coupon and in a short final coupon. Consider, for example, an MTN program that pays interest on March 1 and September 1 and at maturity of the notes. A $100,000 MTN sold on May 1 with a 9 percent coupon and a fifteen-month maturity from such a program would distribute a “short” first coupon of $3,000 on September 1, a full coupon f $4,500 on March 1, and a “short” final coupon of $3,750 plus the original principal on August 1 of the following year. Like corporate bonds, interest on fixed-rate MTNs is calculated on the basis of a 360-day year of twelve 30-day months. Commissions to MTN agents typically range from 0.125 percent to 0.75 percent of the principal amount of the note sale, depending on the stated maturity and the credit rating assigned at the time of issuance. Fees to underwriters of bond offerings are somewhat higher. The administrative costs may be lower with MTNs than with bonds. After the borrower and the investor have agreed to the terms of a transaction in the MTN market the borrower files a one-page pricing supplement with the SEC, stating the sale date, the rate of interest, and the maturity date of the MTN. In contrast, issuers of corporate bonds sold from shelf registrations are required to file a prospectus supplement. These yield spreads are estimated using the model presented in Leland E. Crabbe and Christopher M. Turner, “A Dynamic Linear Model of the Determinants of Yield Spreads on Fixed-Income Securities,” (Board of Governors of the Federal Reserve System, working paper, June 1993). An additional reason for the high credit quality of structured MTNs is that some investors, such as money market funds, face regulatory restrictions on the credit ratings of their investments. See Leland Crabbe and Mitchel A. Post, “The Effect of SEC Amendments to Rule 2a-7 on the Commercial Paper Market,” Finance and Economics Discussion Series 199 (Board of Governors of the Federal Reserve System, May 1992). Banks also issue bank notes with shorter maturities that range from seven days to one year. These short-term bank notes are sold to money market investors with interest calculated on a CD basis or discount basis. As with medium-term bank notes, short-term bank notes are issued at the bank level, and they are not insured. Short-term bank notes differ from commercial paper in that commercial paper is an obligation of the bank holding company. These figures on issuance and outstandings are not directly comparable with those reported in the Federal Reserve’s survey because the DTC totals include bank notes and deposit notes issued by banks, as well as MTNs issued by foreign corporations. See Mark S. Carey, Stephen D. Prowse, John D. Rea, and Gregory F. Udell, “Recent Developments in the Market for Privately Placed Debt,” Federal Reserve Bulletin, (February 1993), Besides meeting the securities test, banks and savings and Funding/Loans must also have a net worth of at least $25 million. In contrast to other investors, broker-dealers must own only $10 million of securities. Bonds and MTNs may be classified as either domestic or international. By definition, a domestic offering is issued in the home market of the issuer. For example, MTNs sold in the United States by U.S. companies are domestic MTNs in the U.S. market. Similarly, MTNs sold in France by French companies are domestic MTNs in the French market. Bonds and MTNs sold in the international market can be further classified as foreign or Euro. Foreign offerings are sold by foreign entities in a domestic market of another country. For example, bonds sold by foreign companies and sovereigns in the U.S. market are foreign bonds, known as “Yankee bonds.” Euro-bonds and Euro-MTNs are international securities offerings that are not sold in a domestic market. As a practical matter, statisticians, tax authorities, and market participants often disagree about whether particular securities should be classified as domestic, foreign, or Euro