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Time to reconsider FRNs?

06 November 2017
Richard Kemmish

In the recent wave of Greek covered bonds one of the lesser noted curiosities was a floating rate bond issued by Piraeus Bank.

Now this may be an exceptional case, it was sold to three supra-nationals, it does bring up again an age old question – why don’t we see more floating rate covered bonds?

The standard answer was a good one – most of the mortgages are fixed rate and most of the buyers want fixed rate bonds. Compelling, but increasingly no longer true.

Much of the recent growth of the covered bond market has been in countries with either floating rate mortgages or mortgages that are fixed for a very short period of time then revert to either floating rate or another short-term fixed rate. National specificities aside, the bottom line is that the duration of mortgages in cover pools is falling all the time. Let’s not get into the debate about whether this is appropriate from a policy perspective again - we’ll save that for a later discussion.

Similarly on the buy side. With yields at such absurdly low levels the motivation to buy covered bonds is more often technical than fundamental. I wouldn’t ever buy a covered bond at these absolute yield levels – neither (I hope) would my pension fund or mutual funds. But my bank and central bank would, whether because of the huge pick up over govvies or because they have been told to by Mr Draghi. The implication of this is a huge shift in the balance of covered bond buyers from those who prefer fixed rate bonds to those who prefer floaters, such as bank treasurers.

Unpredictable pay-down

Then there are the technical arguments. Nearly half of all covered bonds issued now have the provision to become floaters in a maturity extension scenario – whether short-term extension or conditional pass through. Some investors are scared of bonds which have an unpredictable pay down. We can learn from our friends in the securitisation market here – the vast majority of the bonds are floaters, the vast majority pay down on an unpredictable schedule. Whilst some people have fun modelling likely pay-down profiles of securitisations it hardly really matters if it is a floating rate note.

Then there is the swap. Most cover pools are managed on a floating rate basis with vanilla fixed/float swaps being introduced when bonds are launched (aka liability swaps, to differentiate them from the asset swaps that turned the cover pool floating in the first place). A vanilla swap is traditionally fairly cheap, fairly standard technology even when they have to conform to covered bond documentation. But so many things that are happening at the moment are making them more expensive and onerous. More bonds are being issued by lower-rated issuers (credit charge), with currency exposure (Canadian dollar – euro basis swap costs) and with maturity extension features (anyone who has tried to explain that to a swaps credit officer will know the problems).

Plenty of reasons why Piraeus bank might have started a trend?

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