Monday, September 28, 2009
Understanding Bank Instruments, from Bank to End Investor
With so many people trying to broker private placement programs and bank instrument sales, we felt that it was critical to outline the entire process from instrument creation to maturity.
To truly understand the purpose and functions of bank instruments, we must first define what a bank instrument in fact is.
By definition, bank instruments are asset backed notes issued by a bank to an investor which mature over 5-10 years, collecting an annual coupon (“interest”) until it matures at its pre-defined value.
For those who don’t understand why debt instruments, bonds, or notes are created, let’s explain it all in 2 sentences:
Companies, or in our case banks, create paper notes (“IOU’s”) which they sell to investors, guaranteeing a certain annual interest and maturity value. This allows the investor to collect their expected profit, while the bank accesses immediate cash to meet capital requirements for additional financing opportunities.
Unlike its boring cousins (bonds), the bank instrument is rather complex, and is typically referred to as a “hybrid note”. Unique amongst most debit financing notes, bank instruments: collect high annual interest rates, are backed by top rated banks, and are issued ONLY in amounts of 50 Million EURO or greater. Though those are intriguing qualities, the key is: bank instruments can be purchased at a discount from face value, and traded to investors in the secondary market.
Since we understand this topic is rather complex, we created a 5 step summary to clarify the details of how bank instruments evolve. This will explain the relation of bank instruments to private placement programs, and the investment benefits to purchasing bank notes.
Bank Instrument Steps to Maturation
1. Once the investor or trader has been cleared through compliance, the issuing bank will “cut”/create an instrument (Medium Term Note or Bank Guarantee), naming the investor or trader as the sole beneficiary. This instrument will have a predefined interest rate (0-7.5%/yr.), and a value on the date of its maturity. At this point, the purchaser would more than likely pay a discounted rate to the issuing bank, ranging from 60-90% of face value, depending on their relationships and the instrument’s size.
2. If the investor chooses to hold the note, they just collect interest and exercise the value upon maturity. If the initial purchaser was a “trader”, they would have a pre-defined “exit buyer” to buy the note at a higher value (ex. Trader buy at 65, sell at 74). As you can see with spreads like that, if the trader can consistently access instruments, they can organize a very profitable private placement program.
3. Once the first purchaser has purchased the note, they will usually resell it to another buyer at a higher price. Though the buyer isn’t purchasing the note directly from the bank, many private placement programs are run by middlemen who fit right here in the process. Usually, they will purchase the note, and make a profit similar to what was made off of them (ex. Buy at 74, sell at 81). People in this position are usually high net worth individuals, large corporations, hedge funds, etc.
4. The final middle man repeats the process the others have done, but they look for a different type of buyer. In this case, the note has been traded several times, and is at a smaller discount than it originally was. For many that may not be appealing, but for for some that seems intriguing and less “risky”. Since everyone can verify the instrument has been owned by several companies (”seasoned”), institutional buyers such as pension funds, hedge funds, mutual funds, and other low risk ventures flock for security and higher yields. As expected, the final middle man usually sells the note to an institutional buyer for a profit similar to what was made off of them (ex. Buy at 81, sell at 90).
5. The final purchaser holds the note, collecting the difference between the discount they paid vs. face value, and the annual interest until the time of its maturity.
Though the information above is accurate, the spreads per trade may vary depending upon a number of variables. To state the obvious, different traders, banks, relationships, and strategies can make prices/profits fluctuate.
Now that you have gotten a true understanding of what a bank instrument is, as well as its various purposes, it’s time to do some more exploring through our related articles. Take a look below; expanding your knowledge base can only speed up your path to success!
InsideTrade LLC Staff
Submitted by InsideTrade Staff on Wednesday, 19 August 2009