Debt Capital Markets puzzles, solved step by step

Puzzles
100
Traced to a firm
16
Topics
13
Hard
30
Topic
All topicsLeverage, coverage and cash flow9Mental maths and numeracy8Estimation and market sizing7Logic and brainteasers8Cost of capital and valuation riddles7Bond pricing and yield7Compounding, PIK and fees6Issuance and refinancing arithmetic8Credit spreads and default probability8Duration and convexity8Capital structure and recovery8Probability and expected value10Yield curve and forward rates6
Level
AnyWarm upCoreHard
Source
AnyReported at a firmStandard
Showing 1–1 of 1 · filtered from 100Clear filters
  1. 012A Rs 800 crore bond carries an 8% coupon with a step-up of 25 basis points for each notch the issuer's rating falls below AA. It is downgraded two notches. What does that cost the issuer each year?Issuance and refinancing arithmeticWarm upIndian debt capital markets

    Try it first

    Answer in rupees, not basis points.

    Show the worked solution

    Rs 4 crore a year. Two notches below AA, from AA to AA- to A+, trigger two steps of 25 basis points, so the coupon rises from 8.00% to 8.50%. Half a per cent of Rs 800 crore is Rs 4 crore, taking annual interest from Rs 64 crore to Rs 68 crore for as long as the rating stays there. A step-up turns a downgrade into a cash cost.

    How do you convert basis points into rupees quickly?

    Anchor on one basis point. One basis point of Rs 800 crore is Rs 8 lakh, so 50 basis points is 50 times Rs 8 lakh, Rs 4 crore. It works like a fuel surcharge on a bus ticket: a small percentage, but on a large base and paid every trip. Say the conversion out loud; desks talk in basis points and issuers pay in rupees, and the interviewer wants to hear that you can move between the two instantly.

    A step-up turns each notch of downgrade into cash: 25 bps on Rs 800 crore is Rs 2 croreRs 64 cr a yearcoupon 8.00%Rated AAat issueRs 66 cr a yearcoupon 8.25%Rated AA-1 notch downRs 68 cr a yearcoupon 8.50%Rated A+2 notches downTwo notches:+50 bps x Rs 800 cr+Rs 4 crevery yearbars start at Rs 50 crore
    Each notch below AA adds 25 basis points to the 8% coupon, so annual interest on Rs 800 crore climbs from Rs 64 crore at AA to Rs 66 crore at AA- and Rs 68 crore at A+, an extra Rs 4 crore a year after a two notch downgrade.

    Why would an issuer agree to a step-up at all?

    To get a lower coupon today. Investors worried about a downgrade will accept a tighter starting coupon if they are compensated when that fear comes true. A step-up couponA coupon that rises by a set amount if a trigger is hit, most often a downgrade of the issuer rating below a stated level. shifts rating risk back to the issuer: cheap while the credit holds, costlier exactly when the credit weakens. That timing is the catch, and it is what a good answer names next.

    The relationship
    ΔInterest=F×n×s=800×2×0.25%=4 Rs crore a year\Delta \text{Interest} = F \times n \times s = 800 \times 2 \times 0.25\% = 4 \text{ Rs crore a year}
    Fface value outstanding, Rs 800 crore
    nnotches below the trigger, 2
    sstep-up per notch, 25 basis points
    What it says in wordsThe extra interest is the face value times the number of notches times the step per notch.

    What is the hidden danger in the structure?

    It adds cost at the worst moment. A downgrade usually follows weaker cash flow, and the step-up then raises interest, which weakens coverage further and can invite another downgrade. On this bond, Rs 4 crore is small against Rs 64 crore of interest, but many issues carrying the same clause, or a larger step, can turn one downgrade into a spiral. Close with that, and add the limit: the terms of real step-ups vary, some step back down on an upgrade and some cap the total, so read the clause.

    Where candidates lose it

    The easy slip is counting the wrong number of notches. AA to AA- is one and AA- to A+ is two, so the step is 50 basis points, not 25 and not 75.

    The second loss is answering Rs 68 crore, the new interest bill, when the question asked for the cost of the downgrade. Give the difference first and the new total second.

    What the interviewer asks next

    • What does the step-up cost in present value terms if 5 years remain and the discount rate is 8.5%?
    • Why might investors prefer a step-up bond to a higher fixed coupon?
    • How does a step-up clause change the way a rating agency looks at a downgrade?