Japanese PRDC investors face years without a coupon

The continued slashing of interest rates in both the US and Australia in December has dealt Japanese power reverse dual currency (PRDC) investors more bad news. The products are now unlikely to pay coupons for the next few years or be called by issuers, as the yen continues to appreciate against the US and Australian dollar.

The Reserve Bank of Australia cut its interest rate to 4.25% from 5.25% on December 2 last year, while the US Federal Reserve slashed rates to between 0% and 0.25% on December 16. The cuts pushed US dollar depreciation against the yen to 87.8 (compared to 107.98 on July 31) on December 17 and Australian dollar depreciation against the yen to 61.2 (101.66 on July 31).

"PRDCs are very much on the agenda again as the yen appreciates, leaving investors facing long periods of zero interest with little or no probability of the structures being called," says one London-based head of FX structuring.

PRDCs are designed as a principal-protected yield enhancement product for yen investors where the investor swaps, for example, yen Libor by US dollar Libor paid on a yen notional. Maturities are typically around 30 years while many products are callable by the issuer. The yield is often enhanced with a substantial first coupon, after which the investor hopes the dealer will call the product. The payout on a plain vanilla PRDC is usually the maximum between zero and the USD/JPY rate on the coupon date divided by the rate at the initiation of the swap multiplied by the US dollar interest rate minus the yen interest rate.

If the yen appreciates or US dollar rates are lowered, the coupon is also lowered. "For most PRDCs, investors won't see their capital back for 20 to 30 years," says one Japan-based structurer. "Because volatility is so high there is a probability is that dealers will not buy back the products before maturity. Investors may want to unwind the trades on the secondary market, but given the lengthy tenors of the products the value of zero-coupon bonds maturing in 20 years will be trading at 80-85 cents in the dollar."

There remains a possibility that the Bank of Japan may intervene to cap the currency, although the Bank of Japan did start to take action by slashing interest rates from 0.31% to 0.61% on December 19.