Several changes have occurred in the MTN market as a result of innovations in other capital markets. Among the most important changes in the MTN market are the increasing use of "structured" MTNs, the increasing participation by banking organizations in the market, and the development of a system for book-entry clearing and settlement of MTN transactions. Also, foreign corporations have begun to use the MTN market more frequently since the adoption of SEC Rule 144A in April 1990.

Structured MTNs

In recent years, an increasing share of MTNs have been issued as part of structured transactions. In a structured MTN, a corporation issues an MTN and simultaneously enters into one or several swap agreements to transform the cash flows that it is obligated to make. The simplest type of structured MTN involves a "plain vanilla" interest rate swap. In such a financing, a corporation might issue a three-year, floating-rate MTN that pays LIBOR plus a premium semiannually. At the same time, the corporation negotiates a swap transaction in which it agrees to pay a fixed rate of interest semiannually for three years in exchange for receiving LIBOR from a "swap" counterparty. As a result of the swap, the borrower has synthetically created a fixed-rate note because the floating-rate payments are offsetting.

At first glance, structured transactions seem needlessly complicated. A corporation could simply issue a fixed-rate MTN. However, as a result of the swap transaction, the corporation may be able to borrow at a lower rate than it would pay on a fixed-rate note. Indeed, most MTN issuers decline to participate in structured financings unless they reduce borrowing costs at least 10 or 15 basis points. Issuers demand this compensation because, compared with conventional financings, structured financings involve additional expenses, such as legal and accounting costs and the cost of evaluating and monitoring the credit risk of the swap counterparty. For complicated structured transactions, most issuers require greater compensation.

Many structured transactions originate with investors through a reverse inquiry. This process begins when an investor has a demand for a security with specific risk characteristics. The desired security may not be available in the secondary market, and regulatory restrictions or bylaws prohibit some investors from using swaps, options, or futures to create synthetic securities. Through a reverse inquiry, an investor will use MTN agents to communicate its desires to MTN issuers. If an issuer agrees to the inquiry, the investor will obtain a security that is custom-tailored to its needs. The specific features of these transactions vary in response to changes in market conditions and investor preferences. For example, in 1991 many investors desired securities with interest rates that varied inversely with short-term market interest rates. In response to investor inquiries, several corporations issued "inverse floating-rate" MTNs that paid an interest rate of, for example, 12 percent minus LIBOR. At the time of the transaction, the issuers of inverse floating-rate MTNs usually entered into swap transactions to eliminate their exposure to falling interest rates.

While structured transactions in the MTN market often originate with investors, investment banks also put together such transactions. Most investment banks have specialists in derivative products who design securities to take advantage of temporary market opportunities. When an investment bank identifies an opportunity, it will inform investors and propose that they purchase a specialized security. If an investor tentatively agrees to the transaction, the MTN agents in the investment bank will contact an MTN issuer with the proposed structured transaction.

Most investors require that issuers of structured MTNs have triple-A or double-A credit ratings. By dealing with highly rated issuers, the investor reduces the possibility that the value of the structured MTN will vary with the credit quality of the issuer. In limiting credit risk, the riskiness of the structured MTN mainly reflects the specific risk characteristics that the investor prefers. Consequently, federal agencies and supranational institutions, which have triple-A ratings, issue a large share of structured MTNs. The credit quality profile of issuers of structured MTNs has changed slightly in recent years, however, as some investors have become more willing to purchase structured MTNs from single-A corporations. In structured transactions with lower-rated borrowers, the investor receives a higher promised yield as compensation for taking on greater credit risk.

The growth of structured MTNs highlights the important role of derivative products in linking various domestic and international capital markets. Frequently, the issuers of structured MTNs are located in a different country from that of the investors.

The increasing volume of structured transactions is testimony to the flexibility of MTNs. When establishing MTN programs, issuers build flexibility into the documentation that will allow for a broad range of structured transactions. Once the documentation is in place, an issuer is able to reduce borrowing costs by responding quickly to temporary opportunities in the derivatives market. The flexibility of MTNs is also evident in the wide variety of structured MTNs that pay interest or repay principal according to unusual formulas. Some of the common structures include the following: (1) floating-rate MTNs tied to the federal funds rate, LIBOR, commercial paper rates, or the prime rate, many of which have included caps or floors on rate movements; (2) step-up MTNs, the interest rate on which increases after a set period; (3) LIBOR differential notes, which pay interest tied to the spread between, say, deutsche mark LIBOR and French franc LIBOR; (4) dual currency MTNs, which pay interest in one currency and principal in another; (5) equity-linked MTNs, which pay interest according to a formula based on an equity index, such as the Standard & Poor's 500 or the Nikkei; and (6) commodity-linked MTNs, which have interest tied to a price index or to the price of specific commodities such as oil or gold. The terms and features of structured MTNs continue to evolve in response to changes in the preferences of investors and developments in financial markets.

Bank Notes

Banking organizations are major participants in the MTN market. Like other corporations, bank holding companies must file registration documents with the SEC when issuing public securities. Consequently, the Federal Reserve survey captures MTNs issued by bank holding companies. Although most of these MTNs have senior status in relation to other debt outstanding, a few bank holding companies have issued subordinated MTNs. Subordinated MTNs of bank holding companies typically have long maturities of about ten years. Under regulatory capital requirements, subordinated debt with a maturity of five years or longer qualifies as tier 2 capital. In contrast to public offerings by bank holding companies, securities issued by banks are exempt from registration under section 3(a)2 of the Securities Act of 1933. In recent years, a growing number of banks have issued exempt securities, called bank notes, that have characteristics in common with certificates of deposit (CDs), MTNs, and short-term bonds.

Like CDs, most bank notes are senior, unsecured debt obligations issued by the bank. In the event of the insolvency of the issuing institution, bank notes are likely to rank equal with deposits, except in states where deposits have priority over other debt obligations. As with institutional CDs, nearly all bank notes are sold to institutional investors in minimum denominations of $250,000 to $1 million. Bank notes are not covered by FDIC insurance, nor are they subject to FDIC insurance assessments. CDs, in contrast, are insured for $100,000 per depositor. Furthermore, in the event of a bank failure, the FDIC could choose to protect the financial interests of some or all depositors or other creditors without treating bank notes in the same manner.

Like MTNs, bank notes may be offered continuously or intermittently in relatively small amounts that typically range from $5 million to $25 million. In addition, as with MTNs, most medium-term bank notes have maturities that range from one to five years. However, ratings on senior bank notes are typically one notch higher than the ratings on senior MTNs, which are issued at the holding company level. Reflecting these differences in ratings and priority in the firms' capital structures, the yields on banks notes usually are significantly lower than the yields on MTNs of comparable maturity.

Some bank notes, which are similar to corporate bonds, are sold in large, underwritten, discrete offerings that range from $50 million to $1 billion. However, they differ from corporate bonds in that they are not registered with the SEC.

Book-Entry Clearing and Settlement of MTNs

In the early and mid-1980s, high administrative costs deterred some issuers from establishing MTN programs. Among the most significant of the administrative costs were those arising from transferring physical securities to investors. These costs included printing, delivery, safekeeping, messengers, insurance, and recordkeeping. Moreover, issuers incurred significant costs in the disbursement of interest and principal payments to each individual noteholder. According to market estimates, the direct costs of transferring physical securities range from $5 to $30 per transaction. For small offerings, the costs of physical delivery can add significantly to the all-in cost of borrowing. As a result, many issuers refused to sell MTNs in denominations of less than $1 million.