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If I manage a Real Estate portfolio with approximately 400 million in debt, which is roughly 50% Loan-to-Value (the properties are worth about 800 million). Is it possible to synthesize a bond position to effectively pay down the debt? Due to prepayment penalties, actually paying down the debt is not an option. If I recall correctly from my "finance I learned but never applied in the real world", my position as a borrower can be described as:

-X = -S - P + C (as a borrower we are paying interest, so I would have to be short the bond position. This can be synthesized by shorting stock, writing a European Put Option maturing when the loan matures, and purchasing a European Call Option maturing when the loan matures).

To offset these, we would effectively have to become a lender/receive interest, which would re-arrange to:

X = S + P - C (long stock position, going long a European Put Option maturing when the loan matures, and writing a European Call Option maturing when the loan matures).

In the real world, I've only ever entered into contracts for interest rate swaps, so what I'm wondering is:

1) Is this actually achievable/how it works? How would you go about actually executing the transaction?

2) If 1 is true, is this efficient? Is there a better way to go about this?

3) What would the "Stock" be in this scenario? If the loan is fixed with a spread over the UST (for example 130bps over a 5-yr UST that is 200bps for a rate of 3.30%), would the "stock" be the 5-yr UST?

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  • $\begingroup$ It is not practically achievable this way (with Put Call Parity). It may be achievable some other way... $\endgroup$ – noob2 Jun 22 '17 at 18:46
  • $\begingroup$ What are you trying to accomplish by deleveraging ? (Ex. are you worried about interest rate increases on the debt? Or ...). $\endgroup$ – noob2 Jun 22 '17 at 19:05
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    $\begingroup$ Our capital partners would like the fund's leverage to be equal to its benchmark. $\endgroup$ – jeff m Jun 25 '17 at 20:40
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The process of setting aside an amount to pay off debt (without actually paying down debt) is known as "defeasance." This can be achieved by setting up an escrow account or other bank account, where "dedicated" funds are deposited so that the total amount (counting "locked in" interest), will be enough to pay off or "defease" the debt. The payments can be made all at once or over time.

Technically, you are not "prepaying" the debt until the actual maturity date, but you are "matching" the cash flow needed to pay off the debt. That is a "synthetic" process.

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