Big investors replace banks in $4.2tn repo market
Big investors, including hedge funds, mutual funds and real estate trusts, are replacing banks as the biggest users of the overnight funding market that played a key role in the financial crisis.
The repo market, in which borrowers pledge securities as collateral against very short-term loans, was once a popular method for banks to source cheap financing. But the strategy proved destabilising in 2008, when lenders in the repo market lost confidence in mortgage-backed collateral and pulled back on funding.
Since 2008, the repo market has been shrinking as banks have shifted to longer-term financing in response to new regulatory capital rules and other post-crisis pressures. What remains of the $4.2tn market is increasingly being taken up by non-bank entities such as real estate investment trusts (Reits), mutual funds and hedge funds.
These investors are turning to repo to boost returns during an era of low rates. By using more borrowed money, or leverage, they can take larger positions, but they are also taking a bet that markets will remain stable.
Janet Yellen, Federal Reserve chairman, has stressed that rates in the US could stay low even if unemployment and inflation return to more normal levels.
The growing use of repo has been particularly marked among Reits, which have overtaken banks and broker-dealers as the largest borrowers in the market, according to Federal Reserve data. To purchase long-term mortgage assets, Reits have increased their repo borrowings to $281bn, up from $90.4bn in 2009.
Closed-end funds, which invest in assets ranging from corporate bonds to municipal debt, also have increased their borrowing in the repo market, from $2.74bn at the end of 2007 to almost $8bn now, according to Fitch Ratings data.
Industry participants say there is ample anecdotal evidence that other types of big investors are lending out more of their assets to generate greater returns.
“It’s becoming more of a popular strategy,” said one repo specialist at a large bank. “It’s an opportunity to enhance yield and hit the return hurdles that investors are looking for.”
Repo financing is also playing a new role in the marketing of collateralised loan obligations, or CLOs, which are bonds backed by loans to companies. Investors have in recent months rushed to buy the riskiest slices of these bonds thanks to their higher yields, but have been reluctant to purchase highly rated senior slices since returns on them are much smaller.
Some large banks including Société Générale and RBC Capital Markets are now offering repo financing to buyers of the most senior slices of CLOs in the hopes of increasing investors’ potential returns.
“The only topic worth mentioning right now is the search for yield,” said one senior banker involved in the trades. “With that, a lot of hedge funds have been looking to invest higher up in the CLO capital structure while putting leverage on.”
By lending against the CLOs, banks can make money from assets they would not be able to own under incoming new rules. Said the banker: “Since we can’t hold the assets on balance sheet, it is a good way to get exposure.”
Closed-end funds have historically used leverage to help increase their returns. But repo use has been increasing since the market for a type of debt issued by such funds – auction market preferred stock – collapsed in 2008.
“In the low interest rate environment, repo is very attractive,” said Yuriy Layvand, who analyses closed-end funds at Fitch. “They’re taking that money and investing it further out in the yield curve in fixed income assets.”