FIXED INCOME: The road ahead

Fixed income lending has stayed stable while equities business has declined. Lynn Strongin Dodds looks at certain drivers, such as regulation and tapering, that could see bond lending start to rise.

Since the financial crisis, the securities lending industry has had a rocky time. The clampdown on short selling, muted equity capital market activity and low interest rates have taken their toll. Equity lending has suffered and although there has not been a major shift to fixed income, the prospect of the Federal Reserve tapering its bond-buying programme, as well as new banking regulations, could trigger a change in direction over time.

“Currently, there are around $2 trillion (€1.5 trillion) of securities out on loan and the split is 50/50 between equities and bonds,“ says Will Duff Gordon, research director of Markit Securities Finance. “There could have been a move to more fixed income lending but the central banks have stood in the way. For example, the European Central Bank’s long-term refinancing operations made securities lending more attractive because they offered this additional liquidity.”

Market participants did expect to see a boost in equity lending from rising stock markets but so far that has not been the case. According to Markit’s data, lending of Stoxx 600 shares fell to their lowest level for 18 months in December with 1.97% of shares outstanding on loan. At the same time the index surged to levels not seen over the past six years. 

By contrast, the supply of shares in lending programmes has fared better. The aggregate pool of European equity assets currently held has increased in value by 20%, reaching levels not seen since summer 2008.

Markit notes that the excess supply over demand has seen borrow fees tumble since the start of the year. The 1,000 most borrowed European equities have an average benchmark fee of around 70 basis points, a number that has fallen by six basis points since the end of last year. 

Although Markit publishes an aggregated number, firms at the coalface are seeing different levels of activity depending on their programmes. The general view though is that volumes have been depressed since the collapse of Lehman Brothers. 

“We have noted some trends in the volume of fixed income and equities business but the drivers are not linked,” says Alexandre Roques, head of Clearstream’s Automated Securities Lending Plus desk. “The past few years saw equity lending drop mainly because there were fewer merger and acquisition deals, initial public offerings and corporate actions while regulatory changes have driven up demand for fixed income assets. 

“Also, the drive towards fiscal harmonisation has depressed the demand for arbitrage trading on the equities side.”

Chris Holzwarth senior managing director, head of global sales and relationship management for securities finance at State Street Global Advisors, adds: “We’ve seen a move but only from a relative perspective. Equity volumes may have decreased while fixed income volumes have been stable. Any action by the Federal Reserve – tapering or eventual Fed Funds tightening – could produce significant cash market ramifications and increase volatility and more natural shorts.”

Tim Keenan, global product manager at BondLend, echoes these sentiments. “I would not say that there is necessarily a shift from equities to fixed income; both markets are fairly mature in their development. Speaking strictly from a fixed income perspective, I think that when interest rates start to increase, that could precipitate an increase in short activity and hopefully a return of a specials market in government securities. The special market in the US has been very shallow over the past few years.”

Keenan notes that activity in recent years has mainly been in the corporate bond space and to some degree in emerging markets in both the US and Europe. “Lower interest rates have led to more of a focus on the credit side of the fixed income markets. Within the right risk parameters, trading in these markets has seen growth. As a natural adjunct to this, we’ve seen an increase in the lending and borrowing of credit products in the fixed income finance space.”

The current scenario is not expected to look fundamentally different in 2014 especially in Europe where the European Central Bank (ECB) surprised markets with its recent rate cut to the historic low of 0.25%.  There is talk of the Fed turning off the QE spigot and a corresponding hike in rates but if this year is anything to go by, it is hard to predict when that will happen. 

Views vary from tapering to start at the end of the first quarter after the next round of debt-ceiling wrangling, to much later in the year. Many analysts are reluctant to pin their sails exactly to the mast given the turnaround in October which saw the Fed pull the plug on its plans to start trimming its $85 billion monthly bond programme as flagged.

This was mainly due to the economic data not being as strong as predicted and policymakers want to ensure growth is on a more sustainable path before taking action.

“We believe that low interest rates have depressed fixed income lending and if they rose that would make a difference,” says Jeannine Lehman, head of global collateral services in Europe, Middle East and Africa at BNY Mellon. “However, I do not think anyone believes there is a prospect of a rise for next year. The thing that can make a difference is on the regulatory side and the much talked about collateral upgrade trade.”

In essence this is when firms use securities lending to trade low-grade securities such as equities for better-quality assets such as government bonds. The main drivers are Basel III with its liquidity coverage ratio and the European Market Infrastructure Regulation (Emir), which is pushing derivatives trading onto listed exchanges and through central clearing. 

The extra demand they are putting on obtaining high quality collateral is expected to lead to a shortage and securities lending is seen as one way to fill any breach. The magnitude of the gap is a topic of never ending debate with estimates ranging from $500 billion to as much as $10 trillion, although many believe that $2 trillion is a more realistic figure.

Keenan also thinks there will be greater demand for the collateral upgrade trade, wherein a lender who has government collateral could look to lend that out versus a basket of corporate bonds and get paid for it. “As long as the haircuts are sufficient to cover the rates, credit risk and the volatility of the basket of corporates, the trade makes sense. However, the beneficial owner of the government bonds must have the risk appetite to take corporate bonds as reinvestment to make this work.” 

He adds: “Clearly, this trade may not be for everyone, but where there is [demand] it opens up income opportunities for portfolios of government bonds that are not currently being lent out. The demand for this type of trade right now is not that significant.  As the demand, though, for higher-grade collateral increases because of regulations in the derivatives market, we may see more of this type of trading in the future.”

These regulatory changes could lead to a shift in patterns in terms of the demand and supply of fixed income assets, says Sunil Daswani, head of sales and relationship management at Northern Trust. “For example, we are seeing some clients looking at segregating high quality assets in their lending programmes in order to pledge collateral for their margin requirements under the new OTC rules. We are seeing other clients review the traditional liquidity swap style transaction.”    

Holzwarth notes this is not a particularly new trend but that the market has not fully engaged yet. “Popular traded products like US Treasury collateral under 10-year maturities would fulfil the high quality asset characteristic needed for pledging while also being less volatile due to their shorter duration,” he adds.

Lehman also sees a fundamental shift in the way the buy side, who are long fixed income assets, think about their programmes. “Securities lending is no longer a stand-alone product. We are seeing our clients starting to think about lending as a mechanism for either covering their own collateral positions or lending their fixed income assets out for others to use them.”

Keith Haberlin, global co-head of securities lending at Brown Brothers Harriman, though, says: “It remains to be seen if the regulations do create a greater demand for fixed income instruments. What is interesting is that, globally, some of the regulations are competing against each other.

“For example, Dodd-Frank and Emir are forcing asset managers to put up high-quality collateral at the CCP while shadow banking and Esma [European Securities and Markets Authority] rules are going to make it difficult to transform collateral. This could all add up
to a zero sum game.”

©2013 funds europe



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