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Believing impossible things

27 August 2019

“There's no use trying," she said: "one can't believe impossible things." "I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for half-an-hour a day. Why, sometimes I've believed as many as six impossible things before breakfast. – Alice Through the Looking Glass

Covered bonds without an act of parliament? Pricing through the govvie curve? Pricing a new issue with a negative yield to maturity? All were called impossible by some (ok, me too) right up until that moment when they actually happened. 

Is a negative yield more conceptually incredible than the first two? Or am I just taking my time to come to terms with it? We’ve had practice justifying the first two for 16 and 8 years respectively. 

One of the problems is that the first two contravened definitional rules of our market: a covered bond is a bond structured according to an act of parliament that trades as a rates product as a pick-up over govvies. Neither of them would be considered abnormal in, say, the securitisation market. Neither of them would make the interested outsider question the basis of our market.

A negative interest rate on the other hand is patently absurd. I recently had to try to justify it to a friend of mine who is a plasterer. You’ve probably had similar conversations with non-financial markets people? The argument that it might be negative but at least it’s less negative than German government bonds just puts off the inevitable come-back ‘then why would anyone lend money to the German government?!’. 

To understand – and justify - one ‘impossible’ thing we have to predicate at least two things that are far less intuitive and quite possibly downright wrong. In response to ‘why are interest rates negative anyway?’, ‘well, if low rates stimulate an economy, ultra-low rates must ultra-stimulate it’.  Except that experience in Japan and increasingly Europe suggests that this obviously isn’t true (does Mr. Draghi spend half-an-hour a day imagining impossible things?).

Then there is the answer to ‘why would you buy them?’, ‘because I have to buy them in order to have liquid assets’. Old-fashioned bonds – the ones with a positive yield to maturity, remember? – had a real value underpinning them. Someone – maybe a pension fund or an asset manager - would want to buy the coupons and would have a discount rate that would make the purchase make sense for their portfolio. The belief that there is that real money investor out there somewhere allowed banks to own and trade bonds between themselves even if they yielded less than the cost of funding. What you lose on net interest margin you gain on liquidity. That was the basis of our arguments for covered bond’s inclusion in liquidity cover ratio calculations.

But if a bond only exists for liquidity purposes, with no inherent value underpinning it, is it really liquid? Arguably there is an inherent value, but only at the cash price below the current market price where the yields turn positive again (don’t ask me where that is, my beloved HP12C can’t handle a negative yield to maturity on a bond; she has had to be retired. Presumably no-one under the age of 50 reading this knows what an HP12C is, why we hold them in such affection or what reverse Polish notation actually means). Surely the value given to a bond held for LCR purposes should be floored at the price equating to a positive yield and therefore a real demand?  

As we have had so much practice imagining impossible things its fun to speculate what the next impossible thing that will happen will be. Looking forward to suggestions at the Euromoney/ECBC covered bond congress in Munich


By Richard Kemmish 

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