Although the term notes generally designates debt securities with an issued maturity of 1 year or less, medium-term notes (MTNs) are debt securities with maturities that range from 9 months to 30 years or longer. The Walt Disney Company issued a note with a term of 100 years! So notes is a misnomer, but it did describe them more accurately when General Motors Acceptance Corporation (GMAC) first issued them in the 1970's as notes with terms greater than commercial paper, but less than most bonds, so that GMAC could match the terms of the notes with its auto loans.
However, MTNs really didn't take off until SEC Rule 415 was enacted in March, 1982, that allowed a shelf-registration for securities. Under a shelf registration, new securities could be sold for up to 2 years without requiring a new SEC registration for each issue. This greatly reduced the cost of issuing MTNs, since many of these issues were small offerings that were made intermittently over time to match the needs of the issuer.
Today, they have evolved into highly customizable debt securities that serve the special needs of both issuer and investor, and serves as a major source of funding for corporations, government agencies, institutions, and countries.
Most MTNs are noncallable, unsecured, senior debt with fixed rates and investment grade ratings.
The main benefit of MTNs over bonds to both issuers and investors is the flexibility of its structure and documentation. MTNs can match MTN terms with liabilities of the issuer; thus, MTNs are an effective tool of asset-liability management for both the issuer and the buyer. Interest payments can be monthly, quarterly, or semiannually. MTNs can:
- have floating or fixed rates or formulas that tie returns to equity, commodity, or currency prices
- have calls, puts, and other options built into them
- be issued as zero coupons, or have step-up or step-down coupons, or inverse floating rates
- be denominated in a foreign currency, or
- pay interest based on an index
Asset-backed MTNs could be collateralized by mortgages, equipment trust certificates, amortizing notes issued by leasing companies, or subordinated notes issued by bank holding companies. However, most MTNs are issued based on the creditworthiness of the issuer.
MTNs Compared to Bonds
The advantage of medium-term notes is simple: if an issuer can issue a bond that has the specific characteristics that an investor would want, then the issuer can pay a lower yield by providing those exact characteristics.
However, this customization also fragments the market, where each part of the market is smaller than the whole. It is also more difficult to forecast demand for these specialized products, which is why MTNs are issued as a best-efforts underwriting, since most MTNs are sold in small amounts, either continuously or intermittently.
The flexibility of MTNs also allows the issuer to take advantage of temporary market opportunities, since a new MTN with specific characteristics can be issued quickly.
MTNs also make reverse inquiries feasible. A reverse inquiry is a request by an investor for a security with specific characteristics not currently on the market. For instance, an investor could ask for a specific note that matures just when the investor must pay a large expense or have a floating rate interest that is paid quarterly.
MTNs also allow discreet funding, since only the issuer, agent, and investor need to know about a transaction. Thus, the issuer can avoid a large public offering that may indicate that the company is financially distressed.
Although medium-term notes have many advantages, the traditional method of bond underwriting still has its advantages. It is more cost effective to underwrite a large single offering, and the investment bank can make a firm commitment by buying the entire issue from the issuer and then sell it to the public. In this case, the risk of selling the entire issue is transferred from the issuer to the investment bank. Also, bonds from a large offering have greater liquidity in the secondary bond market.
The Medium Term Note Program
To create medium-term notes in the United States, a corporation, institution, or a government entity files a shelf registration with the SEC, typically for $100 million to $1 billion of securities. After the initial application is approved, the issuer files a general prospectus describing the MTN. The registration includes a list of investment banks — typically 2 to 4 — to distribute the notes to investors.
The issuer's agents post offering rates with various maturities. Usually yields are expressed as a spread above another fundamental rate, such as the rate for Treasuries or the LIBOR. However, the issuer varies the spread according to its needs. For instance, if the issuer wants mostly 5 year notes, it will give those notes a higher spread, and less desirable notes, a lesser spread. As the need for a particular maturity lessens, the issuer will lower the spread of the notes for that maturity, thereby lessening the demand.
|Sample Medium-Term Note Rate Schedule|
|Maturity Range||Yield Spread|
|9 -12 months||no rate||Issuer doesn't want to|
issue this maturity.
|12 - 18 months||no rate|
|18 months - 2 years||10|
|1 - 2 years||15|
|2 - 3 years||20|
|4 - 5 years||40||Issuer prefers these maturities,|
so pays the highest rate above
Treasuries with comparable maturities.
|5 - 6 years||40|
|6 - 7 years||40|
|7 - 8 years||25|
|8 - 9 years||10|
To issue medium term notes, most issuers use the services of investment banks, which charge an underwriting spread plus a fee for creating the structured products upon which many notes were based. Since about 2000, investment banks were also issuing their own notes based on their own credit.
The main advantage of medium-term notes is their flexibility for both issuer and investor. This flexibility can be extended by creating structured MTNs — combining MTNs with derivatives to satisfy the specific needs of the investor while reducing risk for the issuer.
For instance, through a reverse inquiry, an MTN issuer may want to borrow from an investor who will accept a lower yield in exchange for a floating interest rate, but the issuer doesn't want to assume interest rate risk, so the issuer may arrange a plain-vanilla interest rate swap with a counterparty, that allows the issuer to pay a fixed rate of interest to the counterparty in exchange for a floating rate payment, usually based on a spread above some key interest rate, such as the LIBOR. However, the issuer will not do this unless the investor accepts a yield low enough for the issuer to cover the costs of creating the structured notes, since these products have greater accounting and legal costs, as well as the costs to assess and monitor the credit of the swap counterparty.
Sometimes structured MTNs are created to take advantage of a temporary market condition. Investment bankers may know of clients with specific needs that can be met by a structured MTN. The bankers will contact their clients with their proposal. If the clients agree, the bankers can contact an issuer of an MTN who would accept the proposal.
Some of the unusual properties of structured MTNs include:
- floating rates based as a spread on some key interest rate, such as the prime rate or the LIBOR rate;
- an inverse-floating rate that moves inversely to a key interest rate;
- LIBOR differential notes that pays the spread above the LIBOR in 2 different currencies;
- dual-currency MTNs that pay interest in 1 currency and principal in another.
There are also structured MTNs that pay interest according to some index, such as an equity index or commodity index. Indeed, the new exchange traded notes being offered by some investment banks are structured MTNs that are traded on stock exchanges, just like stock. Currently, most of these notes pay an interest rate commensurate with an equity or commodity index minus fees that range from 0.4% to 1%.
Medium Term Notes Risk
About 1/3 of MTNs issued offer partial or complete principal protection. However, as with bonds, the principal protection is only as good as the creditworthiness of the issuer. If the issuer declares bankruptcy, then note holders will be unsecured creditors, and secondary market prices for the MTNs will decline substantially.
Example of MTN Risk: Lehman Brothers Declares Bankruptcy
In September, 2008, Lehman Brothers, then the 4th largest investment bank in the United States, declared bankruptcy. Lehman Brothers issued and sold MTNs, in denominations of $1,000, based on the returns of the S&P 500 stock index up until about 1 month before it declared bankruptcy. Lehman Brothers advertised the notes as having uncapped appreciation potential pegged to the S&P 500 index and 100% principal protection that had a worst case scenario where the investor may only get the principal back in 3 years. However, $20 of the $1,000 principal went to dealer incentives. Among the 15 risks cited in its brochure were that there was no interest or dividend payments, they may not appreciate at all, and last, and certainly not least, the principal protection was based on the creditworthiness of Lehman Brothers.
On September 15, 2008, the notes were declared in default, and traded in the secondary market for a price that ranged from 10 - 55¢ on the dollar.
A large market for MTNs also exists in Europe. The percentage of structured MTNs is larger than in the United States, because many of these Euro-MTNs cater to the diverse currency needs in that market.