Interpreting SIGNs - stock index growth notes - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by John D. Finnerty

The rich variety of securities innovations in recent years continues to intrigue academicians and practitioners alike.(1) The array of innovative securities includes a variety of equity-linked debt securities, some of which base the equity component of the security on the share price of a single corporation and others of which base it on the value of a particular stock index, such as the Standard & Poor's 500 Index (the "S&P 500"). McConnell and Schwartz |13~ analyze an example of corporate-equity-linked debt, called LYONs (liquid yield option notes), which takes the form of a corporate zero coupon convertible bond that incorporates both call option and put option features. Chance and Broughton |3~ and Chen and Kensinger |4~ analyze equity-linked certificates of deposit. Chen and Sears |5~ analyze an example of stock-index-linked debt, called SPINs (Standard & Poor's 500 Index subordinated notes), which takes the form of a coupon-bearing note with the principal repayment linked to the S&P 500. They decompose SPINs into debt and equity components, develop a valuation methodology, and demonstrate that the prices produced by their model closely track the observed market prices of the SPINs. This paper deals with a recently introduced security that closely resembles the SPINs: a zero coupon note with the single payment linked to the S&P 500. I employ a valuation methodology similar to Chen and Sears's to try to answer the question: To what extent are S&P 500-linked notes truly innovative?

On January 28, 1991, the Republic of Austria publicly offered $100 million principal amount of stock index growth notes ("SIGNs") in the United States |16~. The issuance of SIGNs raises a number of interesting issues, such as: (i) why would the Republic of Austria issue equity-linked notes whose contingent return is tied to the appreciation in the value of an American share price index, and (ii) is the security innovative in the sense that it represents an investment vehicle whose after-tax and after-transaction-cost returns investors could not duplicate more cheaply with financial instruments already in existence, and if so, what factors are responsible for the net benefit?

I. Description of SIGNs

The SIGNs mature in approximately 5.5 years and make no payments of interest prior to maturity. The prospectus for the SIGNs |16~ describes them as contingent interest notes. The single interest payment, payable at maturity, is equal to the greater of zero and

10 ||P.sub.m~ - 336.69/336.69~

where |P.sub.m~ denotes the average closing value of the S&P 500 for the 30 business days immediately preceding the second business day prior to the maturity date. The initial offering price was $10 per SIGN. If the value of the S&P 500 is below 336.69 on the maturity date, the holder receives $10. If the value exceeds 336.69, the holder gets $10 plus $10 multiplied by the percentage appreciation in the S&P 500 above 336.69. Also, the SIGNs are not redeemable by either the issuer or the holders prior to their scheduled maturity date. The SIGNs were marketed principally to retail investors, and they are listed on the New York Stock Exchange.(2) The financial press reports the daily prices of the SIGNs among the prices of common stocks traded on the New York Stock Exchange.

A. Characterization of SIGNs

SIGNS may be characterized as a package consisting of (i) a 5.5-year zero coupon note, plus (ii) a 5.5-year European call option, or warrant, on the S&P 500 with a strike price of 336.69. Exhibit 1 illustrates this interpretation. The SIGNs were offered for sale on Monday, January 28, 1991. The closing value of the S&P 500 the preceding business day, Friday, January 25, 1991, was 336.07. The call option was approximately at-the-money on the issue date because the strike price is 336.69. The outstanding debt of the Republic of Austria is rated Aaa by Moody's Investors Service and AAA by Standard & Poor's Corporation. Thus, a close substitute for SIGNs that is available to investors is a unit consisting of zero coupon Treasury securities (called Treasury strips), which are readily available in the capital market, and call options on the S&P 500, which are traded on the Chicago Board of Options Exchange. The Treasury strips involve zero default risk; however, the degree of default risk associated with Republic of Austria securities is slight due to the triple-A rating. The call option imbedded in the SIGNs is European-type just like the exchange-traded call options on the S&P 500.

B. Taxation of SIGNs(3)

The prospectus for the SIGNs suggests that they will be taxed as so-called contingent interest notes |16, p. S-13~. The prospectus notes that the Internal Revenue Service had not yet published final regulations governing the tax treatment of contingent interest notes. The proposed contingent interest regulations then outstanding were based on the premise that when the amount of interest that will ultimately be payable is contingent on the future value of an index or some other future event, the tax liability can not be determined until the amount of interest can be established with a reasonable degree of certainty. Because of the risk that the S&P 500 could decline below the strike price of the call option embedded in the SIGNs right up to the SIGNs' maturity date, the amount of interest payable cannot be conclusively determined until the maturity date. Consequently, interest on the SIGNs would not be taxable until the maturity date.