The curious structure of an MTN

The Law and Lore of Repackaging →Go uptown “bond” as explained to my neighbor Phil A bond (also called a “note”, “MTN” or a “debt security”) is a form of loan. It is like an IOU from a company or a government. Instead of taking one big loan from a bank, a company issues lots of little loans, in the form of bonds to investors. To buy a bond is to lend money to the issuing company, who must repay that money by “redeeming” the bond its stated maturity date. In the good old days, bonds were security-printed certificates with the loan terms and conditions printed on them. Repayment to bearer: The company will pay principal and interest to the “bearer” of a bond — that is, whoever holds it, and who turns up on the correct payment date and presents the bond to the issuer for redemption. Interest coupons: If interest is payable, the bond will have coupons — literally, little perforated tabs that you can tear off and present separately — for each interest payment. Hence the expression “coupon” has become synonymous in modern finance with interest. Transferability: Because the issuer pays whoever holds the bond, this means the bond is negotiable — any bondholder can sell its bond to another investor without the issuer’s permission or knowledge. The issuer doesn't care: it has to redeem the same number of bonds, whoever holds them. Electronic trading: Nowadays, almost all bonds trade and settle electronically, inside clearing systems, so there are no certificates or coupons, and everything happens in the blink of an eye. But the principle is the same. Financial concepts my neighbour Phil was asking about when I borrowed his mower. Index: Click ᐅ to expand: Cut out and keep Edit Repack Anatomy: Hedging exemption | Covenant to pay | Quoted Eurobond exemption | Pre-enforcement | The curious structure of an MTNIndex: Click ᐅ to expand: Repackaging Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

You will know old Grandpa Contrarian’s story of the farmer and the sheep. It is illustrated richly in every cove, inlet and waterway of the financial markets, but is no better exemplified than in the genetic structure of a medium term note programme.

These, for the fortunately uninitiated, are architectural structures by which corporations raise funds in the international debt capital markets. Their history is long and mildly diverting at best — the type who naturally deals in debt instruments is not really given to intrigue — but for our purposes it is important.

Conceptual underpinnings

Now: as per the panel summary, a bond of any kind is an IOU, in that it represents an entitlement to be repaid a loan. In earlier epochs one would borrow against a “note” — literally, a signed piece of paper indicating your preparedness to pay a sum to whoever presented it, in exchange for its surrender.

The neat thing about this kind of note is its transferability: the original lender can “negotiate” it — sell it without the issuer’s permission, or even knowledge — and its value will be the present value of the issuer’s promise to pay. A note is a unilateral contract, therefore. A conventional loan is a bilateral contract, and the job of transferring ones rights and liabilities under it is more involved, and often requires the cooperation of the borrower.

The other neat thing about notes compared to loans is that you can easily divide a big borrowing into lots of little notes, rather than a single big one. Thus, you can access a wider pool of lenders — including Belgian dentists, as we will see — each of whom can manage its own exposure without reference to the others, by buying or selling bonds in the secondary market.

Notes therefore are more liquid, transferable things, and while they are outstanding the issuer need not even know who its creditors are: they hove into view only upon payment of principal or interest, when they would show up at the issuer’s office with their instrument in hand.

Industrialisation of debt securities

This all being the case, notes quickly became popular, and the process of issuing, selling and maintaining them industrialised. Notes were “security printed”, like banknotes. Interest payments were represented by perforated coupons that could be detached and presented (or “stripped” and separately traded): for a long-dated bond, where there wasn’t room for all the coupons, there would be “talons” attached entitling the bearer to a fresh strip of coupons. Issuers appointed banks as “paying agents” to handle the mechanics of dealing with holders, paying out on presentation and so on. In some jurisdictions issuers needed to maintain a record of noteholders, so created “registered” notes which were profoundly different in legal concept — title transferred by entry in the register, whereas with a bearer instrument the security itself was the debt and title passed by delivery — and there needed to be terms to deal with certain unwanted contingencies: replacing lost or mutilated notes; provisions for noteholder meetings to consider amendments to terms and so on.

Now an IOU is a simple enough thing: the legal architecture making it all possible was another thing altogether: trust deeds, paying agency agreements, dealer agreements, prospectuses and so on, and the up-front cost of a “stand-alone” debt issuance was formidable. Thus emerged the medium term note programme — a pre-crafted architecture containing all the standard terms, appointments and so on, which an issuer could quickly “tap” when it needed to, in a fraction of the time and cost.

In parallel the information revolution arrived and notes started to trade electronically, in a clearing system. Here noteholders’ interests were represented as electronic entries in their clearing system accounts there was no need for security printing, perforated coupons, a wide network of paying agents, and the identity for the time being of the holders was ascertainable, at least by the clearing system, which had to maintain the records on order to ensure everyone got paid. At the very heart there was still a physically printed note: just one: a “global note”, representing all the nominally issued notes, held by a “common depositary” — a custodian for the electronic clearing systems in which the notes are traded.

Residual DNA

By the 1990s, all notes, bonds and other securities were electronically cleared, and none has been security printed since. Nonetheless, the MTN terms and structure still bear traces of their physical biology, a bit like tailbones, appendixes and male nipples. The basic rationale is “well, the clearing systems might not work one day — you know, there could be some kind of post-apocalyptic, Mad Max-style future with everyone driving round in battle trucks and drinking their own urine — so I might need to change these into security-printed definitive notes, so we better leave these terms in just in case”.

Now the JC would be the last one to pooh-pooh the idea of a dystopian future — given the last few years he rather expects it at some stage, in fact — but, really: if you are eating caterpillars, presenting your coupons to the Luxembourg paying agent is going to be a long way down your list of priorities.

In any case, this useless DNA makes for a great deal more complicatedness than, in practice one really needs. Your bond terms and conditions have to deal with the following:

• Registered or bearer form
• Electronically cleared or definitive
• Where definitive and bearer, mechanics of presenting coupons, talons and so on.

The logical structure of legal documents

On what kind of ball may be used with what kind of game A single, branching proposition where the subject is the ball: 1. A ball: (a) if it is red (i) if it is round (A) must not be used for rugby union (B) must not be used for rugby league (C) may be used for test cricket (D) must not be used for one-day cricket (ii) if it is oval: (A) may be used for rugby union (B) may be used for rugby league (C) must not be used for test cricket (D) must not be used for one-day cricket (b) if it is white: (i) if it is round: (A) must not be used for rugby union (B) must not be used for rugby league (C) must not be used for test cricket (D) may be used for one-day cricket (ii) if it is oval: (A) may be used for rugby union (B) may be used for rugby league (C) must not be used for test cricket (D) must not be used for one-day cricket Two branching propositions where the subject is the ball: 1. An ball that is oval: (i) may be used for rugby (ii) must not be used for cricket 2. A ball that is round: (i) must not be used for rugby (ii) if it is red: (a) may be used for test cricket (b) must not be used for one-day cricket (iii) if it is white: (a) must not be used for test cricket (b) may be used for one-day cricket Three non-branching propositions where the subject is the game. 1. Rugby must be played with a ball that is oval 2. Cricket must be played with a ball that is round and: (i) in test cricket, red (ii) in one-day cricket, white

This leads us on to one of our pet interests: why are legal documents so convoluted, and what can we do to correct it? For this we need to delve into the underlying logical structure of a contract.

Any legal statement, however Fishily articulated, boils down to a basic logical proposition, rather like software code, with propositions, conditions, logic gates, if/then statements, and so on, only we call them definitions, obligations, rights, discretions, options and so on.

Any “logic gate” that splits a proposition into alternatives increases the inherent complicatedness of a proposition.

Take the alternative statements about cricket and rugby balls in the panel at right. The variables at play are:

• round or oval ball
• red or white ball
• rugby or cricket
• test or one-day cricket
• rugby union or rugby league

There are ten variables here, but how you structure them can great more or less complicatedness. If we try to create a single proposition that covers all eventuality, we commit ourselves to a lot downstream branching.

The subject of the sentence and sequence of the branches makes a difference. In the first example the ball is the subject. Since all four codes use a ball, we must explain all of them, and we commit to a permissive “may” rather than a constrictive “must”. If we then put our first gate on the colour of the ball — irrelevant in rugby — we commit to articulating some propositions with no limited significance. As far as this proposition is concerned there is no difference between rugby union and rugby league, but we have committed ourselves to a particular structure that exhausts all permutations, whether or not they have any difference. By splitting proposition in two we can deal with both rugby codes without any logic

See also

• Medium term note programme
• Repackaging programme