In the paper “On the design of Sovereign Bond-Backed Securities”, [1] written together with Damiano Brigo and Marco Francischello (Imperial College), we analyze the design of Sovereign Bond-Backed Securities (SBBS) in the Euro area, concentrating our attention on the return of the different tranches and on their riskiness.
The analysis is performed considering the market on January 31st, 2019, and then is extended to the whole period 2005-2019. The role of the structure of the tranches, the role of the recovery rate, and the correlation among States have been analyzed. More precisely, we deal with:
- the yields of the different tranches (junior, mezzanine, senior) changing the SBBS tranching structure – a tranching 70-20-10 produces a senior tranche (70% of the pool) as safe as the German bund.
- the role of recovery rate in the yields of the different tranches – assuming a positive recovery rate, instead of a null one, as often done in literature, the yield rate of senior tranches goes down and the yield rate of junior tranches goes up.
- the level of (uniform) correlation among States – changing the level of correlation in case of a uniform correlation matrix, the yield rate of senior tranches increases as the correlation increases, while the yield rate of junior tranches decreases; the effect on mezzanine tranches is ambiguous depending on the tranching structure.
Given the unrealistic assumption of null recovery rate and uniform correlation among States, as made in ESRB High-level task force on safe assets (2018) Sovereign bond-backed securities: a feasibility study, Volume I: main findings, we consider also block correlation structures, i.e.
- high uniform correlation (1.00) among non-core States (Portugal, Italy, Ireland, Greece, and Spain)
and
- dividing the countries in two blocks: non-core and other countries (Austria, Belgium, Finland, France, Germany, The Netherlands), with a strong correlation inside the blocks, and a low correlation between the two blocks.
In the first case, we observe that a uniform block structure for the correlation impacts the yield rates of the tranches, with a decrease of the yield of the junior tranche, an increase of the yield of senior and, in particular, of mezzanine tranches. Moving from a uniform to a block correlation structure, we show that the yield rate of the senior tranche remains pretty stable, the yield rate of the mezzanine increases, while the yield rate of the junior tranche significantly decreases going from a uniform to a block correlation structure.
Comparing the effect of correlation and non-zero recovery rate, we prove that it is the second one which impacts the most on the yields of SBBS tranches, with high yields for junior tranches.
We also compare SBBS with national tranching followed by pooling: States issue senior and junior tranches, then senior tranches are pooled together to build an asset backed security. The analysis shows that, as for SBBS, pooling government bonds of different States to build a safe asset renders junior bonds extremely risky.
In summary, the main issue in constructing a safe asset is not the safety of senior tranches but the risk of the junior ones.
[1] Available at SSRN: https://ssrn.com/abstract=3496155
