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Is it possible to use corporate bonds as collateral for loans? (Part 1)

Key take-away

  • Corporate bonds generate cash flow. Therefore, they can be used as collateral for loans. Stocks, bonds, asset-backed securities (ABS) and re-securitizations can also secure a loan
  • The European Central Bank has updated its framework which states that the poorer climate performance that bonds are at, the less qualified they are. 

In May 2020, the Reserve Bank extended the types of corporate bonds that are accepted as collateral under repurchase agreements (repo) by upgrading the rating of corporate bonds from investment grade of AAA (BBB- or above).

Under OCC Rule 604(b)(4), corporate bonds that “(A) are listed on a national securities exchange and not in default, (B) have a current market value that is readily ascertainable on a daily basis, and (C) are rated in one of the four highest rating categories by a nationally recognized statistical rating organization” are  allowed as collateral.

According to the International Capital Market Association (ICMA), stocks bonds, asset-backed securities (ABS) and re-securitizations may also be used as collateral in financial markets. 

At the same time, banking theory includes a definition section on collateral theory in contracting for financial markets, specifying  that corporate bonds generate cash flow (as the creditor pays the debt). Therefore, it is eligible to be used as collateral for loans. 

CASE OF STUDY

Greensill Capital can work as an example. During its heyday, Greensill was hailed as one of the leading providers of supply chain finance (letting firms borrow to pay suppliers). The fact that it used to pledge with corporate bonds issued on the security of a Special-Purpose Vehicle (SPV) owning another package of corporate bonds shows that corporate bonds can, in fact, be traded as collateral for loans. 

In addition, the European Central Bank (ECB) has updated its framework, which continues to accept certain qualifying corporate bonds as collateral, and bonds that are at a poorer climate performance are less qualified: “The Central Bank said it would also limit the share of non-financial corporate bonds with a «high carbon footprint» because it accepts as collateral from individual counterparties, while requiring climate risk disclosure to hit certain levels before an asset or loan is accepted as collateral.”

All in all, the collateral of corporate bonds could be used to guarantee loans and bond other issuances of enterprises. Bonds as collateral, in fact, have a history from when government bonds were accepted as collateral for borrowing purposes. Even in the 2000s, corporate bonds have been commonly used as collateral for loans. Restriction of this was soon declared afterward, but due to the lack of mortgages in the market, which leads to liquidity jams, accepting corporate bonds as loan collateral stayed prominent.

Reece Almond