Loans built into bond pricing
Competitive pressures can only increase the onus on pension fund managers to maximise returns, consistent with the security that trustees and pensioners require.
One of the most important of these techniques is to access the repo or bond lending value inherent in portfolios. Bond lending can be a discretionary activity performed by agent lenders on behalf of clients. Programmes can be structured to provide its participants with the most secure of environments - backed by comprehensive indemnities - in which to generate incremental yield. Repos (sale and repurchase agreements) and securities loans are the most common transaction types by which agents lend out portfolios. Both transactions are attractive because they are governed by the most reliable industry standard documents; the PSA/ISMA for repos and the OSLA for loans. However, the economic result, whether achieved by repos, loans or sell-buyback transactions, is effectively the same.
The repo/bond lending markets are among the fastest-growing financial markets. Though still not as well known as the securities markets themselves, the growth of, for example, the UK gilt repo market points to a higher profile in the future. Nevertheless, the repo markets underpin the underlying cash markets in the most fundamental ways. Traders, directly or indirectly, allow for the repo/bond lending income when assessing the value of a security. As a result, the repo/bond lending value embedded in a portfolio is increasingly recognised as something for which investors have already paid.
This is particularly true in the major government bond markets, where current on-the-run or benchmark issues regularly trade special (ie, specific securities for which there is strong demand resulting into higher repo/ lending income). It is therefore increasingly incumbent on fund managers to lend their securities to extract this value on behalf of their clients. So securities lending, once viewed as an optional extra, is increasingly seen as a central responsibility.
As we have noted, the value embedded in securities reflects the market’s factoring in of a third cash flow into the price (or NPV) of a bond: the revenues earned by lending or repoing it out. Depending on their characteristics, at any given point in time some bonds have more value than others (specials versus GC” or general collateral) in the repo markets.
This can be seen by considering the apparent anomalies regularly found in the major market’s yield curves. One would expect, all things being equal, a given yield curve to be relatively smooth, in a liquid and efficient market. However, at first glance, this appears not to be the case. There are a number of factors which affect why a bond trades expensively or cheaply relative to where a smooth yield curve might predict: for example, whether it is a benchmark issue, its coupon, or the extent to which it is deliverable into a futures contract. The cost of borrowing the bond in the repo market also plays an important role in determining its pricing. The more expensive a bond is to borrow in the repo markets, the more likely it is to be expensive in the cash market relative to its position on the curve.
While one might normally expect such anomalies to be arbitraged out in an efficient market place, it is not surprising that a trader or arbitrageur may be reluctant to sell short an issue which is expensive to borrow. In particular the high cost of borrowing a special may cancel out the profit the trader is anticipating.
Redrawing the yield curve on a “break even forward” basis, adjusts each issue for the bond lending income earned on the repo/lending markets, as well as for the cost of funding. The resulting shape of the curve better reflects the smoothness one would ordinarily expect. Looking at the forward yield curve proves more useful to the bond investor as it reflects an adjusted forward price for each bond which factors in any extra yield earned by lending the bond, net of financing costs.
A bond which appears to be expensive on a relative basis may in fact generate so much money in the repo/ bond lending markets as to make it cheap when looked at on, for example, a three-month forward basis, after incorporating its lending income. Fund managers who buy bonds that are expensive on a relative basis, but don’t lend them out, may be foregoing income to which they are entitled.
Failure to realise this inherent value weakens a fund manager’s absolute performance as well as thatwhen measured against both benchmarks and competitors.
Traditionally, the low-risk way to outperform benchmarks has been over-weighting cheap issues and under-weighting the expensive. However, without an understanding of the dynamics of the repo/lending markets how can investors be sure which issues are which? Moreover, common techniques such as so-called “cash and carry” trades (buying a bond deliverable into a futures contract, selling the appropriate amount of that futures contract and repoing out the bond until the contract expiry) are fundamentally affected by the changes in the bond’s repo rate. Understanding these dynamics is fundamental to the use of an important instrument like futures.
When it comes to performance measurement, it is worthwhile remembering that benchmark indices do not include repo/bond lending returns. The over-the-counter nature of the securities lending markets and the fact that prices are very much governed by variable pockets of supply and demand means it is not possible to calculate a benchmark return for lending bonds. The implications for indexed managers are that their performance can be enhanced by bond lending income without any increase in their tracking error versus the index. For a passive manager who precisely replicates an index and then repos or lends it out, an outperformance is all but guaranteed, where none would otherwise be expected.
Of course it is axiomatic that increasing returns involves an increased risk profile. In the case of repo/bond lending this is centred on counterpart, cash reinvestment and operational exposures. However, by outsourcing the activity to agent lenders, investors can eliminate or restrict their exposures (and costs). Programme managers will usually assume responsibility for the settlement/operations performance while providing indemnities against the insolvency of third party borrowers of client securities. Clients, therefore, can limit their counter part exposures while enjoying the benefits of an income stream which they should be realising because, one, it has been paid for and, two, it makes a positive impact on their performance.”