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A Win On The Premium Bonds

14 September 2016 by Rob Ford

I wish I could report that my numbers had come up on the premium bonds – that alternative ‘savings scheme’ (no mention of a lottery) launched in the UK in 1956 with a secondary purpose of suppressing inflation – but sadly I can’t.

The bonds I want to talk about are a different kind of ‘premium’ bonds.

Late last week Obvion, the mortgage lending arm of Rabobank, launched a new deal from their Dutch RMBS programme, ‘STORM’, with an unusual slant to it – it was priced at a premium. Historically, RMBS deals have been issued at 100.00 (par). There are a couple of major reasons for this:

Firstly they are Floating Rate Notes (“FRNs”). Whilst new issue fixed rate corporate bonds are usually priced relative to a government bond or swaps-rate benchmark, which then involves the calculation of the issue price at the moment of launch, usually resulting in a price at a discount or premium to par, with FRNs, the issue level is determined as a spread vs the floating rate benchmark (usually Libor/Euribor), so it’s the margin over the benchmark that’s set at the moment of launch (e.g. Libor+30bps) meaning the bond simply prices at par to reflect the margin.

Secondly, most RMBS bonds contain an element of unknown principal prepayments, as the exact rate at which mortgage borrowers (of which there are thousands in every deal) may pay off their loans (maybe they move house or refinance) is not known, but is assumed based on typical behavioural experience. If the bonds are priced at par, then the speed of those principal payments makes no difference to the yield of the bonds, it’s just that the deal will be slightly shorter or longer than originally expected.

However, with the current negative interest rate policy in Europe, all bond pricing has become a challenge. We’ve seen fixed rate bonds issued with negative yields, but for high quality FRNs which still pay a positive margin over Euribor there is a further challenge because 3-month Euribor is now at approximately negative 30bps and yet the margin on the bond is often less than that, e.g. Euribor+25bps, meaning the coupon on the bonds should set at -5bps. This presents a problem because there is no mechanism for bondholders to pay interest to issuers rather than receive it. Therefore, there is no choice but for the coupon on the bonds to be set at zero.

The astute amongst you will realise that this presents a small mathematical ‘win’ for bondholders as they effectively receive a few basis points extra yield on their bonds (although some might say that receiving a coupon of zero is hardly a win!). For issuers, the reverse is true but they often suffer a double-whammy. Any fixed rate mortgages in the pool are usually swapped to floating by the issuer, and because a swap is simply a bilateral agreement between the issuer and a bank, the issuer does have to pay the negative interest.

So, Obvion have sought a way to overcome this problem. The answer – pay a higher margin over Euribor and price the bonds at a premium. They also had to overcome one further issue – the mortgage prepayments. To do this they created a deal where any mortgages that do prepay are replaced by new loans, meaning that the outstanding balance of the deal remains the same. The whole deal will then be called on the expected maturity date. Many other issuers wouldn’t be able to do this as they are not large or robust enough. Obvion have been an RMBS issuer via their Storm platform since 2003 and have built an enviable reputation for themselves. Every deal they have ever issued has redeemed on the expected date, and that gives the market confidence that this one will too.

So, how was the deal received? Well it literally went down a storm (no pun intended). They were able to price a jumbo €1.9bn of 4.9 year bonds with a coupon of 3-month Euribor+60bps, but priced at 101.49, to give a yield of Euribor+30bps, at the tight end of guidance and with the deal oversubscribed.

So is this the future of high quality RMBS issuance in Europe?  Certainly for issuers like Obvion it’s likely we’ll see more deals like this, and if it creates big liquid issues like this one that pay positive coupons then that’s good for everybody. For smaller issuers, they will most likely have to keep on paying investors their little zero coupon ‘win’.

Either way – that’s a win-win for everyone on these premium bonds!

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