LDI

Q2 2019 repo update

The brief relief that the market felt over the delay of Brexit until Halloween soon evaporated
July 2019

Rosa Fenwick

Director, LDI Portfolio Manager

LEARN MORE ABOUT THE AUTHOR
Share
Subscribe to our Insights

Risk Disclaimer

The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.

The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Past performance should not be seen as an indication of future performance. The value of investments and the income derived from them can go down as well as up as a result of market or currency movements and investors may
not get back the original amount invested.

The brief relief that the market felt over the delay of Brexit until Halloween soon evaporated, as trade war rhetoric ramped up and the global economy took a turn for the worse. In Europe, economic data disappointed and the potentially overly hopeful expectations of a normalisation of monetary policy were dashed. ECB President Draghi reiterated his support for the market, whether in conventional or unconventional policy; however, this failed to stymie the rally in rates. Of course, a similar story is taking place in the US, as policymakers shy away from their scheduled rate hikes, contemplating at the least a pause and possibly a reduction in the base rate. As the Conservative leadership contest in the UK has whittled its way down to two right-leaning candidates, the potential for a no-deal or hard Brexit has risen commensurately – a fact which was referenced in the ‘Sea-change’ speech by BoE Governor Carney. This, in combination with bad PMIs, has thrown a further negative pall over events and pushed rates ever lower.

The market’s view of where long-term rates could move to in the future is encapsulated in forward rates. The chart below shows the six-month swap rate at spot, one-month forward, three-months forward, six-months forward, and one, two, three, four and five-years forward. Where in previous quarters the market had graduated from expecting the pace of rate hikes to slow to potentially expect a rate cut, this has now become a much higher probability. Forward rates reflected this and fell by a further 0.11% at the one-year point, creating a much flatter curve, with particular depressions between one and two years. Note that since the end of the month, the five-year forward point has fallen by c. 0.12%.

Risk Disclaimer

The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.

The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Past performance should not be seen as an indication of future performance. The value of investments and the income derived from them can go down as well as up as a result of market or currency movements and investors may
not get back the original amount invested.

Related capability

LDI

Repo rates are expressed relative to SONIA. The chart below displays the average repo rates that we have achieved over the past four quarters for three, six, nine and twelve-month repos, shown as a spread to average SONIA levels at the time. The chart shows that repo rates (as a spread to SONIA) have decreased across the term structure from the previous quarter, with a much flatter term structure.

Use our handy glossary to look up any technical jargon you are unfamiliar with. 

This flatter term structure is partially a result of a flatter SONIA curve. The fall from the previous two quarters marks the cost that Brexit had placed on the funding market, which has to some extent masked the trend of repo becoming more expensive due to a reduction in balance sheet. If the cross-currency basis continues to be unfavourable to the UK, then this will further move the somewhat ‘sticky’ balance sheet to jurisdictions where a higher return on equity can be obtained.

As mentioned in the previous quarterly update, there is also more demand coming from the US and Canada where, even without the favourable cross-currency basis, investors are willing to pay higher repo spreads. Another factor is the capital treatment of each bank. If a client has a high capital intensity (bilateral swaps, less liquid CSAs etc), this has an impact on the availability of balance sheet for that client. As with most asset classes, it is rare for funding liquidity to be denied fully, but its pricing point can rise in order to manage the balance sheet usage.

Banks can also differ in their approach to repo, particularly where ringfencing is involved. One approach is the ‘match’ approach – in this case the outright level of repo funding is largely irrelevant, as the focus here is on the spread achieved between their cost of funding and where they supply it to clients. Another approach is using a Treasury function – in this case the absolute level of funding is hugely relevant, as repo funding is merely one weapon in their arsenal to obtain the best returns. If other asset classes offer healthier returns, then allocations will shift, thus lowering total balance sheet availability.

Bilateral repo remains the optimum market access route for liability-hedging investors. Peer-to-peer repo and cleared repo are also available to investors; however, they tend to be thought of as an ‘overflow pipe’, i.e. when market participants’ access to bilateral repo is constrained due to reaching balance sheet limits at a particular counterparties or temporary market effects such as quarter ends. Whilst there have been a few longer-dated repo trades in these latter models, liquidity is largely focused on the shorter maturities (overnight or one week), which is of less utility to pension fund clients than fixing funding for three, six, nine or twelve months. We continue to monitor these alternative repo sources but, for as long as bilateral repo continues to offer good liquidity, cost and ease of access, it is likely to remain the preferred route to the repo market.

Repo funding generally remains cheaper over the lifetime than the equivalent total return swap (TRS) funding for creating leveraged exposure to gilts, and so continues to be used within BMO Global Asset Management’s LDI portfolios. However, pricing for total return swaps can be very bond-specific and, where the bank counterparty can obtain an exact netted position, the rate can be extremely competitive. TRS can be longer dated, with maturities ranging from one to three years, as compared to repo, which typically vary in term from one to twelve months. Hence TRS can be beneficial for locking in funding costs for longer and for minimising the roll risk associated with shorter-term repo contracts. On the other hand, repo more easily facilitates tactical portfolio adjustments and tends to be slightly cheaper. We typically use a combination of repo and TRS for our leveraged gilt funding, striking a pragmatic balance between cost, flexibility and minimisation of roll risk. It is essential to maintain a range of counterparties to manage the funding requirements of a pension fund. We now have legal documentation in place with 19 counterparties for GMRA (Global Master Repo Agreement) and 23 counterparties for ISDA (International Swaps and Derivatives Association) and more are being negotiated.

In general, leverage via gilt TRS for a six-month tenor prices at around the same as repo (on a spread to six-month SONIA), although this is very bank-dependent. Another way to obtain leverage in a portfolio is to leverage the equity holdings via an equity TRS. An equity TRS on the FTSE 100 (where the client receives the equity returns) would indicatively price around 0.07% higher than the repo (also as a spread to six-month SONIA). However, this pricing can vary considerably from bank to bank and at different times due to positioning, which gives the potential for opportunistic diversification of leverage. Another way to leverage a portfolio is through a corporate bond TRS, for example on the IBOXX index. This type of funding is extremely level-dependent and indeed some banks may not quote it. However, recent pricing suggests a funding level around 0.63% higher than repo.

SONIA – Sterling Overnight Index Average

Related capability

LDI

Subscribe to our Insights

Related articles