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Adding return to an indexed portfolio through repo

admin | May 8, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Managing an MBS portfolio against a market index has never been easy. But portfolios that hold MBS pools may have a way to add a stream of excess income through the repurchase or repo market. The difference in repo rates between the most liquid and less liquid assets has widened after the market volatility in March. Conservative repo strategies could earn an extra 35 bp a year with more aggressive ones posting more than 115 bp.

Earning a spread between repo borrowing and repo lending

The approach involves two steps:

Exchanging MBS pools for cash in an initial repo transaction, then
Lending cash against a range of other assets in a second repo transaction

The approach earns the difference between the cost of borrowing cash in the first transaction and the return to lending cash in the second transaction (Exhibit 1). An example helps illustrate details of the approach and its potential risks and returns.

Exhibit 1: An example of a using repo to add income to MBS holdings

Note: Indicative levels as of 5/6/20. Source: Amherst Pierpont Securities

The first step

A portfolio could start by posting $100 million in market value MBS pools as collateral against a $97 million repo loan maturing in one month. The transaction would have all the usual features of a standard repo:

The difference between the market value of the collateral and the size of the loan, or the haircut, protects the lender against a drop in collateral value.
If the market value of the collateral drops below $100 million, the portfolio would need to add cash to bring the position back to the initial mark. And if the market value rises above $100 million, the portfolio would receive cash.
If the portfolio does not perform on the loan, the lender can sell the collateral to recover principal and interest.
After a month, the portfolio returns the cash and gets back the pools
The exchange would entitle the portfolio to all interest and principal from the MBS pools, and the portfolio would pay an annualized market rate on the repo loan of currently around 30 bp.

This first step converts core holdings in MBS pools into cash without selling. Many portfolios collect specified pools that could be difficult to replace. Repo creates liquidity while keeping the pools in position.

From a risk perspective, the first step leaves the portfolio position nearly unchanged. The portfolio still owns the market value risk and cash flows from the pools and holds cash on the balance sheet. The portfolio does have counterparty risk to the lender.

The second step

The potential to add income starts with reinvestment of the cash. Some portfolio might reinvest all $97 million. Some portfolios might reinvest most of the cash and hold onto some in anticipation of margin requirements or in anticipation of expected or stress scenario investor redemptions.

Although the portfolio could reinvest in any asset, it ideally should be one the portfolio can confidently liquidate at par when the repo loan in the first step matures. At that point, the portfolio will need to repay $97 million in cash. That limits the practical set of reinvestment securities to floating-rate debt with limited if any price sensitivity to wider spreads. It’s a small list with typically little opportunity to earn extra spread. Lending the cash back into the repo market, however, addresses the problem from another direction: by matching the maturity of the first repo loan.

In a second repo transaction, the portfolio lends $97 million against assets other than MBS pools. The second repo should match the maturity of the first repo loan and earn a spread over the cost of that loan. The portfolio might make a $97 million repo loan for one month against a basket of $115 million in market value of ‘AA’, ‘A’ and ‘BBB’ non-agency MBS. This second repo loan would also have all the usual features of a standard repo arrangement. The current market rate on a 1-month loan against this type of MBS is around 100 bp.

The net result

The paired transactions leave the portfolio earning the annualized difference between 100 bp earned on the loan collateralized by ‘AA’, ‘A’ and ‘BBB’ non-agency MBS and 30 bp paid on the loan collateralized by agency MBS pools, or 70 bp. If the portfolio’s investment covenants view repo as a cash substitute, then its leverage may be unchanged.

A portfolio could also lend against other types of assets in the second repo leg (Exhibit 2). On the more conservative side, borrowing against agency pools for one month and lending against ‘AAA’ non-agency MBS for one month earns an annualized spread of 35 bp, while lending against ‘AAA’ CLOs earns 55 bp. On the more aggressive side, lending against agency MBS derivatives earns 75 bp and lending against non-investment grade non-agency MBS earns 105 bp. Extending the term of the transaction to three months increases all spreads.

Exhibit 2: Borrowing against MBS pools and lending against other assets can produce a range of spreads depending on asset and term

Note:*Levels for pools indicate the ‘bid’ side of the market, where the portfolio rolls pools into the broker/dealer and the broker/dealer delivers back cash. Other levels indicate the ‘offer’ side, where the portfolio delivers cash and the broker/dealer rolls out securities. indicative levels as of 5/6/20. Source: Amherst Pierpont Securities

Practical considerations

Portfolios heading into any repo transaction need to think carefully about overall liquidity. Standard repo terms do not allow the parties to unwind the arrangement and sell assets. The portfolio will need to rely on other holdings for liquidity during the term of the transaction.

It is also best practice to lend against assets that the portfolio itself understands and trades. In the unlikely scenario where the repo counterparty fails, the lender will need to confidently liquidate assets to recover loan principal and interest. Tri-party repo providers usually allow participants daily online access to views of the collateral securing repo loans, the prices put on the collateral and any margin activity. Monitoring the position typically is straightforward.

Using repo to get liquidity in core MBS holdings and then reinvesting the cash complements similar strategies in MBS. Investor have often used TBA contracts to get MBS exposure and then invested cash in other spread assets. Both are potentially useful ways to give an MBS portfolio a lead in its daily effort to beat the returns of a broad market index.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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