RJR Nabisco Holdings Capital Corporation - 1991 Case Solution

The synthetic debentures comprises of a portfolio one deferred coupon debenture and seven treasury strips with maturities listed in the table above. Note that each of these treasury strips has a face value of $6.75. In reality, it may not be possible to buy a treasury strip with face value of $6.75. However, on a collective basis, Ms Samuels could buy twenty-seven $100 face value treasury strips of each maturity date for every four-hundred deferred coupon debentures. This transaction will create four-hundred synthetic debentures that will be superior to four-hundred cash debentures in every aspect. The price of each synthetic debenture created is $89.31, based on the closing prices of January 15, 1991. On the same closing day, the price of actual cash paying debenture (after accrued interest is added to the price) is $101. Therefore, Samuels could buy the synthetic debentures for a lower price than the cash paying debentures, and enjoying more benefits than the benefits offered by cash paying debentures.

How will the synthetic 13.5% and the RJR 13.5% Debentures perform differently over time? You may want to consider factors including, but not limited to, how the two instruments are affected by interest rate changes, and changes in RJR's credit rating.

The synthetic debenture created by the formerly described portfolio provides a similar set of cash flows when compared to the pay-in-kind debentures. Both of the debentures offer 13.5% cash flows over their remaining life. After May 15, 1994, there is virtually no difference between the two debentures since they both transform into cash paying debentures with same default risk, coupon payments, and face value. However, before May 15, 1994, some of the characteristics of the two types of debentures differ. The debentures offer the same cash flow, but the cash flow from the synthetic debentures is safer because the treasury strips carry a lesser risk of default than RJR Nabisco back cash flow from debentures. Therefore, if the credit ratings on RJR deteriorate, the cash flows from the pay-in-kind debentures will be less certain than the cash flows from the synthetic debentures. This difference in certainty is only limited to the period before May 15, 1994; after this date, both the debentures’ cash flows are equally affected by RJR’s credit rating. Moreover, the company has the option to pay the coupon payments on pay-in-kind debentures in the form of additional issues of the same debentures. The company will have an incentive to issue more debentures to settle coupon payments if the interest rates increase. This is because at higher interest rates, the company has an incentive to issue more debentures at the lower rate of 13.5% payable on its pay-in-king debentures. Therefore, the company will prefer to conserve cash and issue debentures at the lower financing rate. Such a downside is not present in the synthetic debentures because the coupon is paid in cash regardless of the level of interest rates.

How could Ms. Samuels profit from the relative mispricing of the RJR 13.5% Debenture and the Discount Debentures? What advice might she give to the following of her clients, each of whom does not pay any taxes?

a. Client A already owns the 13.5% RJR Debenture.

The relative mispricing of the cash-paying debentures and synthetic debentures (created discount debentures and treasury strips) provides an arbitrage opportunity. An investor could exploit this arbitrage opportunity by selling short the higher priced cash-paying debentures, and using the proceeds to buy the synthetic debentures. The future cash inflows from the purchase of synthetic debentures will more offset the future cash outflows from the short sale of cash-paying debentures. Therefore, the net future cash flows from the transaction is positive. Meanwhile the difference in proceeds from short sale of cash paying debentures, and the purchase of synthetic debentures is $11.7 ($101 - $89.3), ignoring transaction costs. This difference represents an arbitrage or riskless profit that an investor can immediately earn on each transaction.

If a client already owns the cash paying debentures, Samuels may advise the client to sell these debentures and buy the synthetic debentures. The synthetic debentures will offer the same cash flows to the client as their original debentures until May 15, 1994. After this date, the synthetic debentures will actually offer a higher coupon payment. Meanwhile, each client can earn the difference between the price of cash-paying debentures and the synthetic debentures, by replacing the cash-paying debentures with the synthetic debentures. At the current difference in prices, this represents a profit of $11.7 on each debenture held by each client.

b. Client B does not own the 13.5% RJR Debenture.

If a client does not currently own the cash-paying debentures, he is in a similar situation as an arbitrageur. The client can earn arbitrage or risk-less profits by selling short the higher priced cash-paying debentures, and using the proceeds to buy the synthetic debentures. This is profit is also equal to the difference in prices, which is currently $11.7 under the assumption of frictionless markets.

Of what risks should Ms. Samuels advise her clients, if they follow her advice? Would you expect the relative prices to remain as they are on January 15, 1991? What will Ms. Samuels advise later if the relative prices of the 13.5% Debenture and the synthetic change dramatically? What might explain the relative pricing in January 1991 of the Discount Debentures and the 13.5% Debentures?

Samuels should be aware that the debentures of RJR Nabisco are speculative grade. Therefore, the debentures are subject to significant default risk. In case of a default, an investor may not be able to receive any income from the purchase of the debentures. However, an investor who has a short position in the debentures may still be required to make the payments. Therefore, Samuels’ clients, who are engaged in the arbitrage strategy, may suffer losses if the company defaults. In other words, the arbitrage opportunity is not totally riskless, as it is subject to the risk of default of RJR Nabisco. Samuels should ensure that her clients are aware of this fact.

Ignoring this risk of default, the strategy would generate profits whenever the prices of the two debentures are not equal. Due to a dramatic change, if the price of cash-paying debentures decreases below the price of synthetic debentures, the profitable arbitrage strategy will reverse. Investors will make profits by buying the low-priced cash-paying debentures, and short selling the high-priced synthetic debentures. In general, the strategy is based on the buy-low, sell high formula, where a difference in prices will always result in profits as long as the difference is large enough to cover transaction costs. However, the prices of the two debentures are not expected to differ from one another in the long run. Whenever there is a difference in prices, the arbitrageurs will rush to buy the low-priced debentures and sell the high-priced one. This will put upward pressure on the price of low-priced debenture, and downward pressure on the price of high-priced debentures. Therefore, the arbitrageurs will force the prices to move close together until the difference is so low that transaction costs prevent them making any more profits.