Special financial assistance update: Fixed-to-floating bonds are eligible | Insight Investment

A quick recap on the evolution of SFA portfolio rules

In March 2021, Congress passed the American Rescue Plan, which authorized SFA grants to severely underfunded multiemployer plans via the PBGC.

In July 2022, the PBGC issued its final rule detailing how plans must invest at least 67% of SFA grant funding in the PBGC’s definition of IGFI assets.

However, the PBGC left some finer details around which assets are “permissible” as IGFI unclear until July 2023, when it confirmed investment grade structured credit, such as many asset-backed security sectors were permissible, along with investments in passive or active funds (such as mutual funds, exchange-traded funds or collective trusts) as long as they were at least 80% invested in permitted IGFI investments. It also clarified several IGFI exclusions, such as Rule 144A securities, high yield, and convertible bonds.

Notably, while the PBGC had already clarified that floating rate bonds were ineligible as IGFI (given they don’t pay a fixed amount or fixed rate of interest), at the time it confirmed that “fixed-to-floating” rate securities would also be ineligible.

The PBGC has updated its guidance on “fixed-to-floating” bonds

The PBGC updated its guidance again in recent weeks. It will now allow “fixed-to-floating” rate securities as permissible IGFI assets, but securities are only eligible during the fixed rate period up to a year before the coupons are scheduled to switch from fixed rate to floating rate.

Additionally, the PBGC has added “step-up” bonds (i.e., securities where the fixed rate coupons increase according to a predetermined schedule) as permissible IGFI assets.

Conversely, “contingent capital” securities, such as contingent convertible (CoCo) bonds or additional tier 1 instruments common in the banking sector, which typically have a “mechanical trigger” for conversion or write down of value remain impermissible for SFA investments. However, this would appear to differentiate CoCo bonds from certain so-called “bail-in” bonds (which are also prevalent in the banking sector) for the purposes of determining permissible IGFI assets.

The inclusion of “fixed-to-floating” rate bonds expands the opportunity set

The potential IGFI-eligible portion of the “fixed-to-floating” rate bond universe is $840bn in size. Of these, 98% of the securities currently outstanding (by market value) have been issued by banks, as it suits their business models and their regulatory capital requirements.

Potential IGFI-eligible “fixed-to-floating” securities also make up 54% of all investment grade banking sector bonds (excluding CoCos), unlocking over half the sector for SFA IGFI-eligible allocations. In total, “fixed-to-floating” bonds also account for 12% of the entire investment grade corporate bond universe (most of which is also eligible as IGFI assets).

Figure 1: The “fixed to floating” rate market is a sizeable proportion of the investment grade market²

In our view, this is a welcome change for investors of SFA assets. In practice “fixed-to-floating” rate bonds have historically been redeemed by the issuer once the fixed rate period has expired, meaning most have effectively acted as fixed rate in nature, consistent with the recent PBGC guidance. We believe their inclusion also allows investors to achieve greater diversification within the banking sector and a potentially greater range of alpha opportunities to exploit.

The inclusion of “step-up” coupon bonds is also welcome, albeit it is of only marginal impact, given the current market value of the eligible IGFI bonds in this market segment is only ~$1.9bn, split between just three issuers.

We have included a summary of the latest PBGC guidance, including the recent updates in Figure 2 below.

Figure 2: “Fixed-to-floating” rate bonds are now included in the IGFI opportunity set³