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Q3 2019 repo update

The summer lull was marked by high volatility on relatively low volumes
October 2019

Rosa Fenwick

Director, LDI Portfolio Manager

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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 summer lull was marked by high volatility on relatively low volumes as trade tensions, geopolitical crises and of course Brexit ructions conspired to multiply economic uncertainty. As global expectations began the downward trajectory on the financial rollercoaster, central banks matched actions to words in support of potentially fragile economies. Despite this, forward interest rate expectations reached new lows, with a particular highlight (or lowlight) being the full 50-year Euro curve at sub-zero rates in August. Against this backdrop, the flight for safe haven assets increased its momentum, culminating in a corporate debt issuance in Germany in mid-August at a negative yield!

Meanwhile, repo was in the headlines due to a significant funding squeeze in the US, resulting in overnight repo rates jumping to 10%. On the face of it, the combination of the corporate tax date, bill supply and coupon settlements were the cause, however these are not one in a million events and merely served to draw attention to an underlying issue with bank reserve scarcity. Reserves have fallen by around 50% from their peak and these are distributed unevenly across banks further exacerbating stresses. In times past, the market for trading reserves acted as a smoothing mechanism, however regulations such as the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR) have made this virtually untenable. In order to relieve the pressure, the Federal Reserve was forced to step in via Temporary Open Market Operations (TOMOs), however this is only a stopgap measure. To reduce the likelihood for funding spikes in the future, a longer-term solution is required, for example Permanent Open Market Operations (POMOs), an increase in the Fed’s balance sheet or potentially a standing repo facility.

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. Rate expectations have fallen dramatically as the consensus is for cuts to the UK Base Rate over the next few years. 1-year forward rates have now fallen by 0.216% since the previous quarter.

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.

Source: Barclays Live, as at 30 September 2019

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Repo rates are expressed relative to SONIA, and the chart below displays the average repo rates that we have been achieved over the past four quarters for three, six, nine and 12-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 increased across the term structure from the previous quarter, returning to levels last seen in the final quarter of 2018.

Source: BMO Global Asset Management, as at 30 September 2019

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

Whilst repo rates increased over the quarter, the upsurge was driven by pressure from the US repo spike in September. This diverted balance sheet away from the UK from globalised or US-centric counterparty banks and those ‘tourist’ banks who had previously concentrated their balance sheet provision in the UK. These put upwards pressure on the domestic repo market with quarter end quotes at SONIA+35bps or even higher. Excluding September, BMO Global Asset Management’s achieved repo rates were consistent with Q2 2019. The spike in UK repo pricing between these two intra-quarter periods was an average of 0.07% (at the 6-month tenor) – an order of magnitude lower than the US.

Typically, US banks would reflect a significantly higher rise in repo rates – this highlights the need to access a wide range of bank counterparties and to ensure sufficient appetite from the counterparties to accommodate funding requirements. By combining these two elements, it allows the focus to be on price sensitivity rather than constant balance sheet allocations thus obtaining a consistently better cost of funding.

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 access to bilateral repo for whatever reason becomes scarce, either through overuse or market shifts. Whilst there have been a few longer-dated repo trades in these latter models (netting targeted so both bond and tenor specific), 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 12 months. The key criteria for these alternatives to meet to become the market standard are:

  1. Reduction in cost of funding
  2. Increased liquidity
  3. Improved efficiency

 
In terms of comparison, the cleared market for swaps has met and exceeded these criteria and the majority of swaps are now traded in the cleared space, with some impetus provided by the Uncleared Margin Regulation (UMR). Unlike in the swap market, there is no regulatory push towards the central clearing of repo, nor do we expect there to be any time soon. This makes it difficult to envisage a wholesale market shift towards cleared repo.

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 our 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 12 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 20 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 total return swap. An equity TRS on the FTSE 100 (where the client receives the equity returns) would indicatively price around 0.04% 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. The differential between gilt based leverage and equity leverage is compressed at this point in time due to the elevated pressures on the bond funding market.

SONIA – Sterling Overnight Index Average

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