FIXED INCOME: Waiting for lift-off

Fixed income lending will gather pace once prices of high quality assets increase. The pulling of QE was not enough to increase activity, finds Lynn Strongin Dodds. 

In October, the  Federal Reserve closed the quantitative easing (QE) door, though the bank still plans to keep short-term interest rates near zero for a ‘‘considerable time”, as well as replace maturing bonds to keep its holdings at about $4.5 trillion (€3.6 trillion). 

The first hint that this day was approaching was in the summer of 2013, but the sheer expectation created panic and markets tumbled. Lessons were learnt and the next move was clearly signposted and executed.  

The end of QE was expected to boost fixed income lending. So far, though, the surge has not materialised. “We have seen QE finish, but securities lending and repo have not seen a great deal of additional volumes,” says Howard Field, head of the international fixed income lending desk at BNY Mellon.

“The appetite has been dampened by the regulatory impact running alongside tapering. The extra pressure on banks’ balance sheets due to Basel III’s net stable funding requirements and liquidity coverage ratios means there is less financing needed,” Field says.  

David Lewis, senior vice president at SunGard’s Astec Analytics, a capital markets business, says it is nearly impossible to identify any individual influences of tapering because of the changes in the fixed income world due to regulation, such as the European Market Infrastructure Regulation (EMIR) and Basel III. “What we have seen is that the activity in fixed income has increased, but that the returns have slowed down. If the prices and returns rise, then this will attract more people to the market to lend high quality assets that will be needed to meet the new regulations, but at the moment there is no pressing incentive to unlock the extra supply.”

Gareth Mitchell, head of securities finance trading in Europe, Middle East and Africa at Citi, agrees. 

“The right price is not always being offered. Some clients expect that the spreads will increase in the future and that will improve the risk-return profile. For now we are seeing many of these trades done under term or ‘evergreen’ structures.”

“Evergreen” trades are where the term rolls continuously, while “bullet” trades are where a single term ranges from 30 days to 360 days. Preference depends on the borrower, the collateral, margin requirements and assets.

Although fixed income lending may have lost its shine, equities have gained a new lustre. “We are definitely seeing more demand for equity borrowing collateralised by equities and we expect this to continue,” says Mitchell. “This is because when you run it through a risk return model, it is more attractive for many borrowers to use equities to fund their borrowing requirements. We are seeing most lenders willing to accept the main highly liquid indices such as the S&P 500, although some are taking collateral from, for example, the Russell 3000.”

Research from Markit bears this out, showing that equities, which enjoyed a 20% hike in daily revenues in the first nine months, are the driving force behind the US securities lending industry reaching its most profitable year of revenues within the last three.  At the end of September, the sector’s revenue tally was $1.3 billion and it is on track to at least match 2012’s $1.79 billion, an uptick of around 15% from last year. This is a marked contrast from the downward trend seen from 2012 to 2013 when revenue dropped by over $250 million. 

Specials, or those hard-to-borrow stocks from less liquid markets that can command a fee of more than 10%, are particularly in vogue. Their aggregate share of the overall on-loan balance of US equities rose from 1% in January to 1.6% on September 1st.

Overall, Markit figures show that as of 20 November, there was around $1.74 trillion of securities out on loan with the split being $815.9 billion in bonds, of which $159.1 billion was in corporates and $774.2 billion was in equities. 

“For the US market, the Fed reducing its monthly purchases of fixed income instruments should add more supply to the market and pressure rates higher,” says Steve Baker, director of securities finance at Markit.  

However, dealers have adjusted their allocation of balance sheet from low margin, capital-intensive trades into higher margin alternative assets where possible. Furthermore, cash investors who have access to the Fed’s fixed rate reverse repo (RRP) facility have flocked en masse to this programme for quarter-end window dressing, opting to have the zero risk-weighted counterparty on their books to reduce regulatory capital charges of Basel III.   

According to Baker, Markit’s US tri-party repo data also reflects a steady hike over the past year in cash loan values against fixed income collateral, while its securities lending data shows a similar pattern of increasing usage. “The most interesting is how the unexpected change in the Fed’s RRP facility toward the end of September 2014, the adoption of a $300 billion cap on the programme coupled with the modification from a set offer to an auction rate, created a huge increase in volatility at quarter end.”

The overnight tri-party facility, which debuted last September, is one of the Fed’s tools to control short-term rates. It is in response to the end of its bond-buying programme that has flooded the banking system with $2.71 trillion of excess reserves. The RPP enables banks, broker-dealers, money market funds and some government sponsored enterprises to lend cash to the Fed overnight at a fixed rate of five basis points in exchange for US treasuries as collateral. This is expected to gradually rise as interest rates climb.  

Volumes into the RRP have increased dramatically since the programme’s launch with daily usage jumping significantly from $86 billion in the first three months of the year to $339 billion in June. Markets turned jittery though, when the Fed mooted the idea of raising the cap at the end of the third quarter from $300 billion. In the end though it ultimately decided that such a move would “raise the risks for financial markets” that led to the cap being imposed in the first place. 

“In the US, the Federal Reserve Bank’s Reverse Repo programme has changed the cash reinvestment landscape,” says Tim Keenan, global product manager at BondLend. “What we have seen is that much of the short-term cash lending, which had gone to broker dealers, is now going into the Fed’s overnight programme.”

Keenan adds: “It has become a tool for cash-rich investment clients for overnight funding. Broker dealers, due to regulation, need longer-term investments for funding. The cost of this funding is less of an issue, and the fact is that longer-term funding simply costs more. Funding in a broker-dealer has become more of a collateral management or treasury function than a short-term funding operation.” 

The environment is different in Europe. Whereas the RPP introduced a theoretical floor on tri-party repo rates – in effect the Fed will not allow them to drop to zero regardless of what happens in the market – this does not exist in the UK or Europe. Overall, equity and fixed income securities lending revenues have been relatively flat over the last couple of years, with average fees and loan balances holding steady.

This is mainly because of the ongoing supply and demand imbalance with inventories increasing by over a third over the last 24 months to around $4.5 trillion for all European securities. However, the swelling inventory has meant that utilisation rates as well as returns to lendable both stand near new lows. According to market participants, the European lending market has been robust from a beneficial owner’s perspective, with new players coming to the market while existing lenders look to grow and maintain their existing revenues.

As with last year, the challenge has been on the demand side especially as the new capital, liquidity and leverage rules are starting to bite. This has not only impacted capacity but also the volume of business that borrowers are able to transact. On the fixed income front, demand for high-grade sovereign debt remains strong and, like in the US, it is typically conducted under a term or evergreen structure. 

Keenan believes regulations will continue to reshape the dynamics of the market. “At the moment, we are seeing fixed income lending balances falling because of the low interest rates and cash reinvestment restrictions. However, Basel III, for example, is driving the need for high-quality assets, and I expect, over time, we will see an increase in the collateral upgrade trade, whereby lower-quality assets are switched for regulatory high-quality eligible assets.’ 

This is different to five years ago, he says, when the main focus was on general collateral because of the returns that cash reinvestment presented.

©2015 funds europe



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