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Not much interest

24 October 2016
Richard Kemmish

Zero, or negative interest rates are, for those of us who write about bonds, the gift that keeps on giving. So far I’ve written about the impact of the ECB’s policy on covered bonds with reference to, secondary market liquidity, investor book homogeneity, yields on substitute assets, triggers for amortisation events and, saddest of all, the final obsolescence of my beloved HP 12C. Those readers below the age of 40 will have no idea what that last point was about, now you know how we feel.
But what about the impact on that most neglected of covered bond topics currently: credit?  As a dual recourse instrument there are two areas to look at. The impact of negative rates on one is more obvious than on the other.
Despite the best efforts of the European Commission to argue otherwise, negative interest rates are clearly a negative for the credit of the banking system.  Incidentally their argument seems to be that the bad bits about negative interest rates – such as paying to put money on deposit at the ECB / not being able to charge a negative interest rate on customer deposits – are less significant than capital gains on fixed income securities (which will eventually net to zero) and improvements in asset credit quality across their loan book (empirically, obviously rubbish).  

The negative impact on bank credit is then exacerbated by negative interest rate’s cousins; flat yield curves and low inflation. 

The credit effect on the assets in the cover pool is less obvious.

On the one hand, mortgage repayments are more affordable. But as we don’t really care about credit in a benign environment, the problem is affordability in a rate hike cycle. This could be an argument for cover pools with high duration assets (fixed rate mortgages) or for cover pools where underwriters and regulators look at stress-tested payment shocks on affordability. The voluntary disclosure of debt to disposable income ratios is a useful tool.

But if a rate hiking cycle is associated with higher arrears it isn’t necessarily associated with higher losses. Certainly for older mortgage pools the house price appreciation which has accumulated has created a nice buffer for homeowners against equity depreciation. A frequent, automatic indexation of the loan-to-value profile of the pool in the face of volatile house prices is useful as a trigger for remedial action.

The least obvious implication of negative rates on the credit quality of the cover pools is on the relative balance between primary assets and derivatives, and on covered bonds whose calculations are on a present value rather than a nominal basis.  PV based systems with high and matched duration assets and liabilities have effectively bonds worth 130% of par backed by assets worth 130% of par. Nominal based systems with swapped floating rate assets and fixed rate bonds have mortgages worth 100 plus swaps worth 30 to back a bond of the same present value.

But whether this is better or worse for credit at the margin, if bank standalone credit is getting worse, the protection offered by covered bonds is getting more important.  

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