The market has learned the hard way that assets that appear liquid and stable one day may suddenly become illiquid the next. While subprime mortgages will forever be the poster child for this quick change, other products including the bonds of some formerly respectable countries may also get into trouble. We see an opportunity for trouble in clearinghouses accepting corporate bonds as collateral for futures, options, securities lending, repo and OTC derivatives trades.
While the CME and LCH.Clearnet do not accept corporate bonds today, the OCC (formerly the Options Clearing Corp) does to a limited degree. According to OCC Rule 604(b)(4), corporate bonds can be accepted as collateral if they “(A) be listed on a national securities exchange and not in default, (B) have a current market value that is readily determinable on a daily basis, and (C) be rated in one of the four highest rating categories by a nationally recognized statistical rating organization.” There is also a 70% LTV on the value of the position.
Our concern with accepting corporates, even with this limited acceptability criteria, is the potential for a liquidity squeeze. The OCC are no pushovers when it comes to risk management, but we are much more comfortable with equities than corporates (many equities are also accepted by the OCC under Rule 604). If CCPs are going to take corporates, we see the right LTV as closer to 40% than 70%. We just do not see how even the smartest risk manager can avoid the potential liquidity risk that comes with even highly rated corporate bonds in a time of crisis; cash and government securities seem like much safer bets.
If corporates are going to be accepted however, this creates an odd opportunity for issuers. If certain corporates become sought after as collateral and can be used interchangeably with other corporate bond investments, an issuer that can meet the criteria above may be able to get improved pricing on their issuances. The market has odd dynamics indeed.