How often do you buy/sell debt with buyback options?

[Chuck Dreison]

I’ve been chatting with a fund manager about our performing notes.

He asked a question I hadn’t heard before...

Would we be willing to buy any loans back if the borrower goes 90 days delinquent?

Typically, when funds acquire loans, they assume delinquency/default risk in exchange for earning a yield on their investment.

Yet this would work differently – it’s a request to purchase debt alongside a corresponding put option/insurance policy.

From the buyer’s perspective, as long as the seller remains solvent, with sufficient liquidity for any exercised options, it’s a risk-free investment. Any delinquent loans are “put” back on the seller.

From the seller’s perspective, it requires managing the complexity and liquidity requirements of outstanding options.

To compensate for the transference of risk, notes with put options trade at a lower yield.

- Sellers receive payment for the loan and a premium for the option.

- Buyers earn a reduced yield but hold a valuable option.

Much in the same way that equity yields are reduced in up markets when bought with put options.

How often do you buy/sell debt with put options? Any interesting experiences?