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First world problems

20 August 2015
Richard Kemmish

The ’First World Problems’ twitter account parodies problems that are only problems because everything else in our life is fine, problems that most of the world, or ourselves a few years ago, would find incomprehensible (“My TV has less pixels than my phone”). I was reminded of that when I heard that the most common complaint of covered bond investors now is illiquidity.

The creditworthiness of covered bonds isn’t a problem – upgrades are now back where they belong, outnumbering downgrades, covered bonds have been held up to the light and found to be whole.

Investment performance isn’t a problem, with both absolute interest rates and spreads so low, are there any bonds out there that are worth less than you bought them for?
Frankly, liquidity isn’t really a problem in the traditional sense of the word. Historically investors have been most concerned about liquidity in the sense that they couldn’t sell a bond that they owned. Now the real problem is liquidity on the buy side – I want covered bonds more than my ability to buy them. This in turn is a result of having to buy in secondary because of the squeeze out in the allocations process in primary.

Admittedly, illiquidity is also about opacity. I can’t judge the true value of my holdings because no one ever trades the bond in question. But this is surely more of a problem for our investor’s middle office – the people tasked with calculating a portfolio value each month end – than it is for the investors themselves, who clearly have no intention of selling (as is illustrated by the fact that there isn’t any selling going on).

There are some initiatives that might help to improve price transparency, but ever since the crisis started there have been many such initiatives - from daily auctions to the ‘Packmohr plan’ -  none have ever worked.

The securitisation market does not share our ‘first world problem’ of only worrying about liquidity. But liquidity is a concern there too. It is a greater problem there for three reasons: the heterogeneity of the asset class, the greater reliance of investors on marking their bonds to market and, yes, lower levels of liquidity than in the covered bond market.

A lot of thought has gone into the problem there. Entire companies have sprung up to calculate the values of all bonds based on pricing references from just a few known data points. The heterogeneity is a problem, each issuer has many different securities outstanding, all of which have their own credit characteristics (as opposed to being pari passu as covered bonds are), but one that can be solved with a bit of maths (actually quite a lot of maths, beyond me).

If mark to model is good enough for regulators, auditors and product controllers in the more complex, volatile and heterogeneous market that is RMBS, then surely we should be able to come up with something reasonable to value our covered bonds?

But then what problems would we be left to worry about?  

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