Some issuers are selling callable CP to mitigate exposure to increased liquidity back-up costs caused by Basel III standards.
Worries about the impact of Basel III’s liquidity coverage ratio (LCR) are prompting debt issuers to sell callable commercial paper (CP). The reason, according to a Fitch Ratings report, is that the cost of bank-provided commercial paper back-up liquidity lines is expected to increase under Basel III due to higher capital and liquidity requirements for banks.
“As a result, we expect borrowers to pursue alternatives to existing short-term funding programs that rely on back-up liquidity,” Fitch said in its report. “The alternatives include callable securities, which are designed to reduce the cost impact of the liquidity coverage ratio (LCR) by extending banks’ liquidity commitments beyond 30 days.”
Callable securities give issuers the right to redeem the asset at predetermined prices at specified times prior to maturity. Therefore, according to the Securities Industry and Financial Markets Association (SIFMA) the yields on callable bonds tend to be higher than yields on non-callable bonds “because the investor must be rewarded for taking the risk the issuer will call the bond if interest rates decline, forcing the investor to reinvest the proceeds at lower yields.”
The Basel Committee introduced the LCR to make sure banks had a reliable funding structure that was in accord with the liquidity of the assets they held; it was also to make sure those assets would endure during times of stress. Although banks have several years to conform with the new requirements, they have been racing to achieve early compliance. One way has been by “paring down and/or increasing the cost of liquidity facilities, which could adversely affect short-term issuers reliant on bank-provided liquidity lines,” Fitch said.
So far there has not been any meaningful LCR-related increase in the cost of borrowing or a reduction line of credit access for short-term issuers, Fitch said. But ratings firm said this was likely due to “the protracted implementation timeline and uncertainty about the applicable run-off rate for the LCR denominator or assumed run on bank liquidity.”