Collateral opportunities - a shift of the risk pendulum
Many beneficial owners participating in securities lending programs in 2017 experienced rather lackluster performance. The absence of volatility in global markets and the predominantly one directional movement of both domestic and international markets resulted in limited opportunities, leaving many participants with lower revenue on a year-over-year comparison basis.
However, despite the relatively weak performance of securities finance revenues linked to hard-to-borrow or “specials,” participants with a diversified lending strategy and higher risk tolerance appear to have debunked this trend of disappointing revenues, ending the year with above average returns relative to the market.
The success of such beneficial owners can be attributed to a combination of factors, particularly an increased appetite to engage in non-traditional strategies, such as collateral transformation transactions, and an expansion of their program’s risk appetite to include alternative cash collateral reinvestment structures.
If the risk profile of beneficial owners were to be equated to a pendulum, the risk pendulum started to swing away from the equilibrium point of intrinsic lending during 2017 - and accelerate towards an increased risk appetite to include longer dated transactions and alternative reinvestment strategies. This shift in risk mentality has had a direct correlation on program performance, resulting in higher revenues for beneficial owners adopting such a strategy, enabling their program to outperform their lending peers.
Securities lending participants would be well-served to reevaluate their risk tolerance in order to take advantage of current conditions with their non-cash and cash-collateral reinvestment strategies in 2018.
Beneficial owners have understandably maintained a more risk-averse posture in the wake of the 2008 financial crisis, which witnessed losses attributed to cash collateral reinvestment. At the time, a strategic shift toward intrinsic-based lending, with a focus on indemnified reinvestment products, was considered a prudent approach for beneficial owners who committed to participating in securities lending. As this risk aversion subsides, however, sophisticated participants are increasingly shifting from intrinsic-only lending and conservative reinvestment strategies to increased credit and duration exposures as a means of capturing greater yields.
While the exact timing and frequency of the Federal Reserve’s rate-tightening regimen—which, at present, includes, almost certainly, three or four additional hikes in 2018—has yet to be determined. What is certain is that the market is already pricing in higher rates over the next couple of years. Within this context, beneficial owners can certainly capitalize on the market opportunities by increasing their exposure to credit sensitive instruments in the cash collateral market.
A shift in strategy
To date, a majority of securities lending portfolios have adopted an overnight-only lending strategy combined with cash collateral investments limited to government money market funds or US Treasury collateralized reverse repurchase agreements. However, a trend has emerged among beneficial owners to broaden their risk profile in an effort to capture incremental yield while utilizing their portfolio of idle assets. This shift is predominantly driven by depressed yields on these reinvestment products.
The Overnight Bank Funding Rate (OBFR) has become the securities-finance industry’s main benchmark for pricing rebate rates on loans, as well as a proxy for the risk-free rate. A majority of lenders will loan securities at a rate linked to OBFR, usually at a spread of 5 to 10 basis points below the daily published rate, which currently stands at 1.16%. Assuming a financing rate of around 1.06% (OBFR less 10 bps), reinvestment yields of a portfolio would need to surpass 1.06% to maintain a positive spread. With government money funds yielding approximately 0.95% and UST collateralized repurchase agreements hovering around 1.05%, the opportunity to lend securities linked to OBFR at a rate of less 10 basis points are limited at best to an intrinsic based or hard-to borrow, strategy. Chart 1 illustrates the current conundrum:
Chart 1: Overnight Repo vs. OBFR
Source: Bloomberg & BNP Paribas
Despite the negative spread or inversion of rates between OBFR and traditional risk-free reinvestment products such as government money market funds and UST reverse repurchase agreements, investors can nonetheless achieve higher returns by allocating a portion of their cash collateral to prime money market funds, private funds or short term bond funds, as well as through adopting a broader collateral schedule for their reverse repurchase agreements.
The implementation of the SEC’s Money Market Reform in October 2016, and the subsequent shift of nearly $1 trillion of assets from prime funds to a stable NAV of government funds, has created a nearly 35 basis-point spread between these two types of funds. Yields on traditional money market products, such as commercial paper, certificates of deposits, corporate bonds and even asset-backed securities, have widened, presenting opportunities for those with a higher risk tolerance. As an example, these short-dated instruments offer yields in excess of 1.25%, presenting ample spread between the OBFR funding rate of 1.06%, for limited risk.
Of course, such changes in strategy can lead to heightened market liquidity risk, interest rate risk as well as duration risk. However, all of these can be mitigated using fairly straightforward portfolio risk-management techniques, such as limiting the weighted average maturity of the portfolio as well as implementing a duration-matched lending program. Applying minimum levels of overnight liquidity to a portfolio as well as concentration limits on an issuer or asset class basis may also help reduce portfolio risk.
Finding an agent capable of properly managing a credit-sensitive portfolio is paramount for institutional investors. For those with in-house capabilities, the option also exists to self-manage cash collateral in order to maximize the portfolio’s total investment return.
Opportunities to monetize current market spreads are not only limited to cash collateral reinvestment strategies. Participants engaged in a non-cash collateral program also have the ability to substantially increase their returns through the expansion of their permissible collateral and extending the tenor of their loans. Equivalent opportunities exist for lending participants to increase their program’s yield through the acceptance of non-traditional repurchase agreement assets, such as high yield bonds, equites and even securitized assets. Several lending agents are willing to indemnify these transactions with customized haircuts and tenors to offer substantial increases in interest rate spread.
According to a representative of a large insurance company,
“Our participation in a securities lending program is designed to maximize our return while adhering to the risk tolerance of our institution. The ability to monetize market opportunities through the expansion of our permissible collateral and engage in longer tenor transactions while maintaining ample levels of liquidity under a fully indemnified program is prudent and in the best interest of our shareholders.”
Whether you opt to participate in the growing trend of adding credit exposure to your cash collateral portfolio, or expanding the scope of your indemnified collateral schedule outside of government debt, guidelines should be implemented which adhere to your institution’s risk profile.
One solution to capturing current market opportunities through an allocation of credit sensitive instruments, while adhering to your unique risk profile, would include implementing a hybrid approach to your collateral strategy. This is similar to the analogy of a checking or savings account where the checking account is your government money market fund or overnight US Treasury collateralized repurchase agreement, while your savings account allocation is the equivalent of your credit sensitive portfolio with longer tenors and credit sensitive instruments. A combination of both strategies is considered prudent while adding potentially significant returns.
Ensuring proper portfolio protections
Despite the opportunity to boost incremental securities-lending returns through broader collateral guidelines and credit-sensitive instruments, any changes to existing portfolio strategy should be discussed with your lending agent to ensure the appropriateness of these portfolio management approaches. Using proper risk controls to determine an acceptable allocation between your “checking and savings accounts” is prudent, as is defining concentration limits, liquidity parameters, collateral liquidation procedures, interest rate mismatch and indemnification policies. Taking these steps, while also adopting a customized, tailored approach to program management, can in turn lead to substantial value for the beneficial owner.
The year ahead
Regardless of your risk appetite, now is an opportune time to begin conversations with your lending agent to discuss your options. It is prudent to reassess your current program and understand the capabilities and willingness of your lending agent to provide a customized, bespoke lending program suited to your risk profile.
It is imperative that beneficial owners understand the capabilities of their provider to offer alternative solutions to their current lending program. Providers exist in today’s market willing to accommodate your risk appetite, offering a plethora of strategies to maximize revenue, while protecting the capital of beneficial owners.
As the pendulum continues to swing away from the equilibrium point, be ready to monetize the opportunities. Finally, as a beneficial owner, have the conversation with your lending agent, challenge your lending agent and engage with a provider to best serve your portfolio of assets. Opportunities exist to increase revenue on traditionally idle assets - so be engaged, educate your management and implement strategies to monetize these market opportunities.