Another problem with low interest rates

11 Mar 2016 | Richard Kemmish


Most bonds are worth more than par. That’s not necessarily a good thing if you are an investor – you might have swapped the fixed coupon and now have a swap with a negative value equivalent to the bond’s positive value (and a swap counterparty nervous about their credit exposure to you). Or – depending on what sort of investor you are - you might not be able to sell the bond without generating a tax liability. Or you might just be worried about the fact that, all other things being equal, bonds further from par are less liquid than those closer to par.

In covered bonds though there are a couple of extra things to worry about.

Acceleration of claims is something that we structurers all do our best to avoid. We don’t always succeed. The possibility of time subordination – longer dated bonds becoming de facto subordinated to short dated bonds in a post-default scenario is generally considered a more grievous sin than acceleration, so all classes of bonds have to enter pari passu pay down.

To be clear, this can happen under ‘traditional’, ‘soft bullet’ or ’conditional pass through' structures, I am not implying that any one of these is any better than the other in this regard. Although it is worth pointing out that extendible bonds (‘soft bullet’ if you must) are less likely to enter their own form of (limited) pass through until after their scheduled maturity date – when an investor should be holding them at par anyway. As they flip to a floating rate basis on this date they will always represent a nominal claim of par, or very, very close.

The problem with acceleration is that you get par value back earlier; great if bonds are worth less than par, lousy otherwise - as is more often the case nowadays. Obviously longer dated bonds, with more duration, are more likely to be worth more than par in a falling rate environment so, the supposed beneficiaries of the acceleration clause are most likely to actually lose economic value because of it.
 
Then there is the extreme case of failure: fire sale of the asset pool. Based on an extremely small straw pool of 10 year covered bonds, most were trading for more than one plus the committed over-collateralisation level. That is, the bond costs more than the nominal value of the assets backing it. That is ok if the assets have a fixed rate coupon (or swap) sufficient to cover the difference, but a bit of a problem if you are trying to recover the market value of the bonds form a fire sale.

It is worth pointing out that extendible bonds (‘soft bullet’ if you must) are less likely to enter their own form of (limited) pass through until after their scheduled maturity date – when an investor should be holding them at par anyway. As they flip to a floating rate basis on this date they will always represent a nominal claim of par, or very, very close.

Plenty of reasons not to like bonds far away from par. Just to float an idea, why doesn’t an issuer offer investors a re-coupon of an existing bond – I pay you today to accept a lower coupon for the rest of the bond’s life? Everyone gets lower swap exposure (therefore credit costs), an easier credit analysis and more liquidity.  


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