Power-reverse to the future: falling yen revs up PRDCs again

Pressure on Japanese unit sparks revival in power-reverse dual currency notes

Yen dollar screen

Depreciation in the yen is sparking new growth in a powerhouse of early 2000s’ investment patterns – the power-reverse dual currency note.

The yen, which hit a 20-year low of 130.4 to the US dollar on April 29, has lost around 10% this year and is currently trading at 127 to the greenback. Betting on the further depreciation of their national currency, Japanese investors are turning in numbers to PRDCs.

And while not hitting the highs of its millennial heyday, PRDC investment in the first quarter of this year is roughly double what it was in Q1 2021, say dealers.

“Interest in long-dated FX-linked structured notes has been very active this year, especially in the January to March period, when JPY/USD moved a lot,” says a head of non-linear FX and rates trading for a European bank in Tokyo. “This year, [PRDC investment] is maybe 100% above what it was in Q1 of last year.”

PRDC notes are long-dated FX-linked structures that offer investors a carry trade in which foreign currency interest rates – such as US dollar – are paid on a yen-denominated notional amount. This means investors – typically medium-sized Japanese banks and corporates – will receive bumper coupons so long as JPY does not appreciate against USD more than the rate implied by the USD/JPY forward market over a 20- to 30-year period.

If the yen appreciates significantly against the dollar, however, investors could face up to 30 years of coupons paid at zero.

The notes can be viewed as a package of FX call options on which investors receive USD call/JPY put options and pay JPY interest rates on the coupon dates. Many PRDC notes sold in Japan also have callable features, in which Bermudan FX call options – which can only be exercised on set dates – are sold back to the dealer, allowing investors to earn further enhanced coupons until the notes are called by dealers.

With monetary policies in Japan and the US becoming more and more divergent since the end of last year, PRDC payoffs are looking increasingly attractive to clients, say dealers.

“So far, the Bank of Japan continues to have an easing policy, despite the rate hikes in US and other countries,” says a derivatives head at a second European bank in Tokyo. “There’s a stark contrast with the US and large yield-spread difference. In this situation, it makes sense to bet on a weaker JPY.”

Dealers say the recent downcycle in global equities has also aided investment, with structured product investors now searching for alternatives to equity-linked structures such as in the fixed income markets.

“One other factor is equities starting to fall and even coming off the last couple of months,” says the non-linear FX and rates trading head. “Equities were quite popular last year, but since Q3 the theme for equities has not been quite so strong and some money went into FX or even rates structured products. There has been a bit of rebalancing towards fixed income.”

A further reason for this latest surge in investments stems from existing FX-linked structured products knocking out as the yen began to depreciate against the dollar. Dealers say a large number of products knocked out when USD/JPY surpassed 120 in March. Following the knockouts, money was reinvested in PRDCs, adding yet more growth to already swelling investment volumes in the product.

“When it happens, some clients reinvest in the same kind of PRDC issuance, which creates issuance volume,” says the non-linear FX and rates trading head.

Once bitten

The notes have a somewhat chequered history. Large and unexpected FX swings have in the past – most notably in the 2008 financial crisis – resulted in losses for investors forced to unwind positions while markets were in turmoil, and in risk management challenges for dealers.

For dealers, risk management challenges stem from the array of interrelated cross-risks the notes generate, including FX, interest rate, basis and correlation risks.

Risk management can become especially tricky during periods in which JPY appreciates against USD. When this happens, dealers need to re-hedge – typically by buying yen calls – as their short positions, generated by the currency options embedded in the PRDC notes, become amplified. Poor liquidity in the markets for basis swaps and FX options has sometimes made re-hedging very costly.

But dealers are adamant that the market for PRDC notes is much safer today than in 2008. The size of the risk inventory at PRDC swap dealers is now much lower than it was back then, they point out – and lessons have been learned about hedging these products.

“[Dealers] are running a lot of cross-risk matrixes in order to anticipate where their risks would be depending on the market,” says the derivatives head at the second European bank in Tokyo. “The whole idea is to anticipate what the risks would be – change and act promptly. Desks can also decide to run some macro hedges to cover some specific adverse market scenario.”

The non-linear FX and rates trading head says a 2008–2009-type scenario, in which JPY appreciates substantially against USD, would inevitably result in some difficulties for swap desks managing PRDCs. But better awareness of the difficulties that can produce such scenarios should keep losses contained.

“We try not to make the same mistake twice, so if we see there is big risk of a move, we are better prepared now – and we know now how to better mitigate the risk for the book.”

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