Power Reverse Dual Currency (PRDC) bonds are the latest instruments causing havoc in the financial world. This product which have been typically issued in Japan has a average maturity of 30 years with coupons linked to movements in a foreign currency such as Austrialian Dollar or US Dollar.
When the yen weakens against the relevant currency, coupon rises, but the issuer can 'call' or cancel the deal after the purchaser receives a certain return.
It allowed Japanese investors to enjoy a leverage form of the carry trade, where Yen is sold to purchase more risky currencies.
However, the deleveraging of assets in the financial markets has driven Yen to record levels instead of the steady depreciation of the Yen as widely assumed by markets. PRDCs are structured such that when a certain level of exchange rate is breached, the coupon stops but the note is still valid.
With strong volatility and strengthening of the Yen, instead of the bond being called early, banks are now struggling to hedge the longer term problems of the FX exposure and currency option embedded in the PRDC bonds. This left them short in the Yen and with Yen strengthening, the problem was amplified. Dealers had to buy Yen calls or Yen spot which accelerated the Dollar/Yen downward move.
Japanese investors have sought higher returns using US swap rates and recent rally in Yen resulted in dealer having to enter the 30-year swap market to stem rising losses. This has caused the 30-year swap spread in recent weeks to fall 60bps below the yield of the Treasury bond.
Eric Tan, London
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1 comment:
Multiple points of pain in PRDCs! Mrs Watanabe is also stuck with 30y JPY zeroes.
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