Targeted Accrual Redemption Note (TARN): What It Is, How It Works

What Is a Targeted Accrual Redemption Note?

A targeted accrual redemption note (TARN) is an exotic derivative that terminates when a limit on coupon payments to the holder is reached.

Target accrual redemption notes (TARN) have the distinguishing feature of being subject to early termination. If the accumulation of coupons reaches a predetermined amount before the settlement date, the holder of the note receives a final payment of the par value and the contract ends.

Understanding Targeted Accrual Redemption Notes (TARNs)

A targeted accrual redemption note is essentially an index-linked note that has a set amount of coupons that represent the target cap. After the target cap is reached, the note will be terminated with the par of the note being paid. So there is usually an attractive initial coupon combined with the possibility of getting back the par value relatively fast. An index-linked note is an investment product that combines a fixed-income investment with additional potential returns that are tied to the performance of an equity index such as the S&P 500 index. 

Aside from these index-linked features, TARNs are similar to inverse floating-rate notes where the benchmark may be Euribor or a similar rate. TARNs can also be conceptualized as path-dependent options: the end-user in effect buys a strip of call options while selling a strip of put options with a notional value that is double the calls'. The contract may include a knock-out provision that terminates it if the benchmark reaches a certain level. 

Foreign exchange TARNs or FX-TARNs are a common form of TARN in which counterparties exchange currencies at a pre-determined rate on pre-determined dates. The amount of currency exchanged varies depending on whether the rate is above or below a set forward price. 

Valuation of Targeted Accrual Redemption Notes (TARNs)

The valuation of targeted accrual redemption notes can be challenging because the redemption timelines are dependent on the coupons received to date. Once the knock-out level is reached, the investment is ended and the principal is repaid. From an investor's perspective, a great initial coupon rate for a time and an early return of capital is an ideal outcome. However, depending on how the indexed rates perform, an investor may be stuck in the investment and see the time value of money erode what was once an attractive shorter-term investment.

Generally speaking, the value of a note is the present value of the par and coupon payments. However, there is uncertainty with targeted accrual redemption notes because not all coupon payments will necessarily be received. So instead of a linear calculation on present value, a TARN requires a simulation of interest rate volatility to assess the probability of triggering the knock-out level given the terms of the note. TARNs tied to volatile benchmarks will necessarily be more difficult to accurately value.