Repurchase Agreements: When do they count as leverage?
Repurchase agreements (‘repos’) are often used by fixed income managers as a means of adding value to portfolios. Despite their use in portfolios investors may be unaware of the nuances associated with these transactions. These nuances are particularly evident when addressing the question of "Whether utilising repos involves leveraging a portfolio?"
What is a Repurchase Agreement (‘Repo’)?
While the term repo is used generically to cover all types of repurchase agreements it is specifically utilised to refer to a type of transaction in which a money market participant can acquire immediately available funds by selling securities while simultaneously agreeing to repurchase the same or similar securities after a specified time, at a given price which typically includes interest at an agreed upon rate (see Figure 1).
The risk associated with lending on a repo (the repo buyer) is mitigated by the provision of collateral by the party borrowing on the repo (the repo seller) which can be sold in the event the repo seller defaults. The rate paid on the repo is determined by overall money market conditions, the competitive rates paid for comparable funds in related markets and the availability of eligible collateral. Although repos are structured legally as a sale and repurchase of securities, it behaves economically like a collateralised or secured deposit/loan. The principal use of repos is to facilitate the secured short term borrowing and lending of cash. The key advantage of repos is due to the provision of collateral, the cost of borrowing is substantially cheaper than alternative sources.
The role of repurchase agreements
Repos can be utilised by active managers in up to four ways. Namely active managers can use repos to:
1. Invest cash secured against the asset provided as collateral -- safe investment (pay cash).
2. Borrow an asset in order to sell and establish a short position or to deliver in order to settle a sale that has already been agreed -- short-selling and short-covering (pay cash).
3. Borrow cash in order to finance a long position in an asset, in an amount and at a repo rate that reflects, the collateral provided to the lender -- cheap borrowing (receive cash).
4. Earn a return by lending out an asset that is in demand in the market, in exchange for cheap cash, which can be used for funding or reinvested for profit -- yield enhancement (receive cash).
The key with respect to each use is whether the investor is receiving (borrowing) or paying (depositing) cash. In terms of considering leverage within a portfolio the relevant uses are those where the investor is receiving cash; i.e. cheap borrowing and yield enhancement.
When is accessing cash via a repo leverage?
Though it is tempting to assume that using repos to facilitate ‘cheap borrowing’ or ‘yield enhancement’ is effectively equivalent the implications for leverage are potentially more nuanced. To highlight the potential nuances the definition of leverage can be viewed from either a ‘receipt of cash’ or ‘use of cash’ perspective.
From a ‘receipt of cash’ perspective any asset manager who is using repos to receive cash is utilising leverage. This perspective focuses on the act of receiving additional cash beyond the level of initial capital to identify leverage within a portfolio. Under the ‘receipt’ of cash’ definition there is no effective difference between ‘cheap borrowing’ and ‘yield enhancement’ in terms of leverage.
By contrast the ‘use of cash’ definition identifies leverage according to how the cash received from the repo is utilised. Under the ‘use of cash’ definition leverage is not the act of borrowing cash but rather the act of utilising the cash borrowed to gain an exposure to the ‘market’ which is greater than the capital of the investment. It is under this definition that a difference between ‘cheap borrowing’ and ‘yield enhancement’ arises in terms of generating leverage. When considering the ‘use of cash’ definition of leverage, the critical issue is the characteristics of the assets purchased. Using repos to facilitate cheap borrowings implicitly assumes that there is a marked difference between the nature of the repo transaction and the assets purchased. An example of this transaction would be where government bonds are repoed for 90 days by an investor to buy long duration corporate bonds.
Yield enhancement by contrast implies that the cash received is utilised to buy assets with similar characteristics to the repo financing them. An example of this transaction would be using a 90 day repo on government bonds to receive cash and then using the cash to buy 90 day bank bills. As the characteristics of the repo providing the cash and the assets purchased with the cash are similar there is no net market exposure created. This is important as matching the term to maturity of the repo and asset purchased reduces the risk around changes in market liquidity and the changes in ‘haircuts’ associated with rolling repos. In this instance it could be argued that there is no leverage created by the repo. The complication with yield enhancement is that if yields are to be enhanced, the characteristics of the repo and assets purchased can be similar but not the same. In this case, while the terms to maturity are the same the manager is enhancing yields by borrowing on a secured basis (repo) and lending on an unsecured basis (bank bills). Just how similar the characteristics between the repo and the underlying assets purchased need to be for the net transaction to not be defined as leverage is very much open to interpretation.
Repos are quite a simple type of transaction which can often be incorporated by active fund managers to enhance returns. Investors should be sensitive to the potential for repos to leverage the portfolio. By more closely matching the repo characteristics with the assets purchased the investor can reduce the risks around these transactions. Despite this, the suitability of repos to access cash within portfolios that do not explicitly allow for leverage, remains debatable. With such nuances around the entire subject of leverage, investors should remain wary of utilising repos and ensure that the most conservative parameters are adopted. Particular attention needs to be paid to the nature of the assets which are being purchased with the repo cash and the risk associated with potential mismatches between funding and assets.
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Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...