RJR Nabisco Holdings Capital Corporation

Mercer and Associates was a money management firm founded in 1975 that specialised in making fixed income investments. As of 1991, the firm managed approximately $2 billion in client assets. Mercer managed the fixed income portions of corporations pension plans, academic institutions endowments and wealthy individuals private portfolios. Valerie Samuels, who analyzed and traded high yield bonds for the firm claimed to notice discrepancies in the prices of certain bonds issued in conjunction with the leveraged buyout of RJR Nabisco in 1989 In 1988, two main bidders proposed to take over RJR Nabisco in LBO. The firm was later bought by KKR and the deal included the following to the share holders $81 per share Package of bonds valued at $28 This translates into a 41% premium over the firms pre-takeover market value which was trading at $77.25.The LBO resulted in an increase in RJRs debt from $5 billion to $29 billion RJR Bonds:Three bonds were issued to raise funds to repay a portion of interim financing used to finance the acquisition.KKR obtained $5 billion in interim financing structured in the form of Increasing rate notes placed privately. Three bonds were issued whose proceeds were used to pay off the increasing rate notes and they are as follows: 13.5% subordinated debentures 15% payment-in-kind subordinated debentures Subordinated discount debentures All three matured in 2001 after 12 years. All of them were rated B1 by Moodys and B+ by S&PThe similarities are summarised in the following table
SUBORDINATED DISCOUNT DEBENTURE May 15 1989 $4.1 Billion May 15 2001 0% through May 1994 and 15% thereafter May 15 and Nov 15 of each year No coupons till 1994 and cash only thereafter 25% on May15 1999 and May 15 2000 Callable after May 15 1994

Issue date Issue size Maturity Date

13.5% SUBORDINATED DEBENTURE May 15 1989 $0.5 Billion May 15 2001

15% PAYMENT IN KIND DEBENTURE May 15 1989 $1.0 Billion May 15 2001

Coupon Rate Payment Dates

13.50% May 15 and Nov 15 of each year

15.00% May 15 and Nov 15 of each year cash or additional bonds till 1994 and only cash thereafter 25% on May15 1999 and May 15 2000

Payment Method

cash 25% on May15 1999 and May 15 2000 Callable after May 15 1994

Sinking Fund

Call feature

Callable after May 15 1994

The major difference among the three securities is the form in which interest is paid. The cashpaying bond is more expensive than the other two bonds. For example, a portfolio consisting of the deferred-coupon bond and Treasury strips could be constructed that provided higher cash flows and less default risk than the 13.5-percent cash-paying bond, yet during mid-January 1991 there was a pricing error of $11.19 per $100 of face value. This is shown in the tables below. A preference for cash paying bonds is observed in this case.
Cost of RJR 13.5% subordinated debentures Cost of synthetic 13.5% bonds Arbitrage opportunity Arbitrage opportunity per dollar of face falue $1,005.00 $893.07 $111.93 $11.19

Treasury STRIPS May 15, 1991 November 15, 1991 May 15, 1992 November 15, 1992 May 15, 1992 November 15, 1993 May 15, 1994 May 15, 2001 RJR Discounted debentures Total

Ask 97.94 93.06 89.81 86.31 83.03 79.72 76.56 41.56 491.3

Proportion needed 67.50% 67.50% 67.50% 67.50% 67.50% 67.50% 67.50% 100.00% 90.00%

Cost 66.11 62.82 60.62 58.26 56.05 53.81 51.68 41.56 442.17 893.07

Possible reasons for the existence of the arbitrage: Inefficiencies in the short-selling mechanism: it may not have been possible to exploit the arbitrage opportunity by short-selling the cash-paying bond and using the proceeds to buy the cheaper deferred coupon bond. When bonds are borrowed to sell short, the security lender keeps the proceeds of the sale as collateral to ensure that the borrowed bonds will be returned. In addition, the investor is required to post up to additional collateral beyond the short-sale proceeds. These margin requirements limit the extent to which an investor can use leverage to establish an arbitrage position. Risk of increased cost to cover position entered into during the short sale either due to illiquidity/unavailability or rise in the price of the borrowed asset (cash paying bond). Issue size: If the issue sizes of the securities were sufficiently small, then the anomaly could be unknown to investors or too small to exploit. However this was not the case with the RJR bonds. Taxes: A taxable investor must pay taxes on the accrued interest of the deferred-coupon (bond and on the cash interest of the cash-paying bond. He will also have to pay a capital gains tax on any capital gains/losses incurred over the period of time that the bonds are held. Seniority of repayment in the event of default: A bond which has higher seniority i.e. will be repaid earlier would have a higher price as investors would factor in the probability of recovering their investments in to the bond price. However the three RJR bonds have equal priority per dollar of bankruptcy claim.