Enron Corp - Credit Sensitive Securities (harvard Business Case Solution)

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In addition to that, investors could not participate when the contract of a bond was created. As a result, they could only find the most appealing bond among others without having a saying about the rate, the price, and the time to maturity. Ultimately, they needed to take all the risks that were associated with the bonds that they bought without having a “safety net.”

The creation of the credit derivatives such as Credit Sensitive Notes gave investors opportunities to minimize their credit risks and the problems we mentioned above. The Credit Sensitive Notes ties coupon rate to the future credit rating of the company. The management would have incentives to lower the credit risk to achieve a higher credit rating, so the company could pay lower coupon payment. The investors, on the other hand, would have a sense of security since they would be reimbursed in the event of credit rating drops.

As a result, our group thinks credit derivatives are more efficient regarding to managing credit risk because on the one hand, it motivates management to perform better, and on the other hand, it creates a ‘safety net” to investors.

Question 5: The Enron credit sensitive note (CSN) is an example of security with embedded credit derivative to manage issuer credit risk. What are the benefits to the issuer of such a note?

A credit sensitive note (CSN) is an innovative way to borrow started at Enron, and it was a fixed or floating rate note designed to lower the price risk for bonds by paying a different coupon payment (coupon rate reset) as the firm’s credit level changed. Take a fixed rate rating sensitive note for example. Instead of having a single coupon rate, which is the case of a common fixed rate note, a rating sensitive note has a list of coupon rates with each rating category having a different coupon rate. If the issuer does not default, the coupon rate will be determined at the reset date. The value will be the coupon rate in the list corresponding to the issuer’s current rating. At maturity redemption will be paid in full. If the issuer does default, only the recovery value of the redemption will be paid (Altman, 2002, p.2). As a result, it is an example of security with embedded credit derivative because it allows investors to manage issuer’s credit risks.

Several benefits to the issuer of such a note are listed as following: (1) The notes were intended to send a signal to the public that the Enron was more creditworthy than it appeared (Although, it could end up affecting its credit rating and accelerating the demise in reality). (2) It provided investors with a sense of security that the company would find a way to compensate them in the case of default or changed credit ratings, and in turn, led to easier borrowing. (3) According to the prospectus for Enron’s notes in Exhibit 9, there was a discrepancy between its pricing and market rates. At the time, the market rate for notes issued by companies with BBB credit ratings was significantly higher than what Enron was offering its investors. As result, it was possible that Enron could provide its investors with a lower rate thanks to its credit sensitive notes program.

Question 6: What can you infer about the Enron perception of its own future credit standing?

The coupon rate of the credit sensitive note depends on the credit rating of the company. Improvements in the company’s credit rating only reduce the coupon rate of Enron’s credit sensitive note by small proportion. However, declines in the company’s credit rating will cost the company significant premiums to investors. As a result, Enron must be very optimistic of its own future credit standing and believed that it could perform better than what they did in recent years, so that the credit rating would be higher in the future.

Question 7: As a buyer of Enron CSN, how would you analyze its value? What are the benefits to the buyer of this issue?

Without Enron’s credit sensitive notes, the holders of Enron’s bonds would receive the constant coupon of $9.5, no matter how the firm’s credit level changes. However, Enron could improve the value of bonds as showing below:

For example, Enron Corp had a current credit rating of BBB-. There was a 84% possibility that the company would remain at the current the credit level, a 7.5% possibility to move down to the BB+ level, and a 8.5% possibility to move up to the level tom BB. The coupon payment was $9.4 for BBB bonds, $12.13 for BB+ bonds, and $9.5 for BBB- bonds. Based on the numbers mentioned earlier, the final coupon payment should be 9.5*0.84+9.4*0.085+12.13*0.075=9.7>9.5. As a result, Enron's credit sensitive notes could improve the value of Enron’s bonds.

There were two main benefits for the buyers of this issue. First, Enron's credit sensitive notes gave investors higher returns because the rate only dropped by a small increment for any credit rating improvement that Enron made. In the event of Enron’s credit rating drop, on the other hand, investors would receive a significant premium from the company, and the actual return of the bonds would go upward compared to regular bonds (as we have demonstrated above).

In addition to the previous points, we believe that it was safer for investors to buy Enron’s credit sensitive notes for the following reasons. First, if the credit level of Enron improved, the default risk for the company would decrease, and the spread risk would increase. However, the decreased amount of risk would offset the increased amount, which indicates a safer investment choice. On the other hand, if a company’s credit level went down, the largely decreased spread risk could offset the default risk using the same logic mentioned earlier.

Second, as a well-performed company, Enron had the competency to pay back its debt and obtain a higher credit rating. According to its financial reports, the company’s asset-liability ratio went down from 25.82% to 24.78% (based on our calculations), and the solvency ratios went up from 15.156% to 18.2% from 1988 to 1989. Moreover, according to the Exhibit 8 in the case, we realized that the Enron Corp believed that company would have a positive perspective of its future performance because the management was confident that the credit rating would go up.

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