Structured finance meets negative rates

Over the summer, we had a brief look at one corner of the bond market that won’t go negative: CLOs.

Senior tranches of collateralised loan obligations are typically priced at a spread over a benchmark, such as euribor. But many of them also include so-called “euribor floors”, which mean that the benchmark cannot fall below zero.

Three-month euribor is currently -0.42 per cent. If the tranche is structured to floor it at zero, that’s an additional 42 basis points of income in the spread, compared with the pricing of risk and reward elsewhere in the bond market.

This week, Owen Sanderson at Global Capital had a fascinating look at the latest machinations in this world. Trading desks are looking for owners of these tranches, so that they can strip out the euribor floors and sell them on.

From the article:

One managing director in rates structuring said he was putting on this trade with internal counterparties which held CLO bonds, while a veteran CLO investor said he’d encountered enquiries driven by this trade.

“People who are long this asset can either keep the floor, and monetise the intrinsic value of the floor as it pays coupons, or come to us, and monetise it up front,” said the rates structurer.

He points out that new issues have begun to incorporate the advantage of the floor in the spread at which they are priced. 

Structured finance, as reflected in the regulatory environment over the past decade, was the villain of the last financial crisis. CLOs in particular are seen as a riskier part of that market (they’re not included as eligible collateral at the ECB, for example), compared with, say, covered bonds. 

But in the covered bond market, a distinguished European financial innovation that dates back to the 18th century, negative rates are rife. This week, two deals attracted insufficient demand, though they still went ahead. Both of them were offered at negative yields.

Joost Beaumont at ABN Amro says today that this was a sign of the mood souring:

...we think it is too early to say that the last two deals mark a turning point in the primary market, but it is clear that investors have become more reluctant.

There hasn’t really been a backlash against negative rates yet, partly because of an absence of alternatives. There’s no sign of that changing.

But we are nonetheless in the strange situation where structured finance, a post-crisis pariah in Europe, offers protections against the tide of negative rates that other low-risk assets cannot.

Related links:
The corner of the bond market that won’t go negative - FT Alphaville.