Bond funds might shift strategies in response to OTC rule changes –Moody’s

New over-the-counter (OTC) derivative margin rules are likely to prompt bond funds to alter their investment strategies, says Moody’s Investors Service in a Special Comment.

The rules on the mandatory clearing of most standardised OTC derivatives through central counterparties (CCPs) will come into force in mid-2013 in the US and Europe. The rating agency believes that the move to standardised OTC derivatives would leave residual portfolio credit risks and increase operational costs.

“The rule changes could entail the need for extra staff with the expertise to manage the exposures, thereby increasing a fund’s costs, and/or render some hedging arrangements as imperfect as funds take measures to counteract the extra costs of initial margin requirements,” says Soo Shin-Kobberstad, a Moody’s Vice President – Senior Analyst and the author of the report.

Under the rules, CCPs will require users of derivatives, such as bond funds, to deliver collateral through the posting of initial margins.

If derivatives are uncleared, the new derivatives regulation will establish more stringent initial margin requirements outright.

In addition, parallel regulatory initiatives, which impose significantly greater capital set-asides for dealers that provide uncleared derivatives, will likely increase the cost of uncleared derivatives transactions.

The latest Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Commissions (IOSCO) document presents its final recommendations on a majority of the initial margin rules for uncleared derivatives.

One of the key elements is the BCBS-IOSCO recommendation for a universal initial margin threshold of €50m. Moody’s believes this threshold will provide significant relief for smaller firms that would have been disproportionately affected by the margin rules.

“Despite the threshold, initial margin requirements could lead to a drag on investment returns for many bond funds as initial margins will become standard practice across the market for both cleared and uncleared OTC derivatives,” the report noted.

To reduce the cost of using OTC derivatives, some funds may choose to use less costly replacements such as standardised OTC derivatives or exchange-traded bond futures instead of customised derivatives that are tailored to their specific needs. Whilst lowering costs, these shifts could lead to bond funds holding imperfect hedges or additional credit risks in their portfolios,” explains Shin-Kobberstad.

Moody’s subscribers can access the report via this link:

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