CHAPTER
FIFTY-EIGHT
FINANCING POSITIONS IN THE BOND MARKET

FRANK J. FABOZZI, PH.D., CFA, CPA

Professor of Finance
EDHEC Business School

STEVEN V. MANN, PH.D.

Professor of Finance
Moore School of Business
University of South Carolina

Leveraging strategies require that an investor borrow funds. There are several well-established arrangements in the bond market for borrowing funds. The most common practice is to use the securities as collateral for a loan. In such instances, the transaction is referred to as a collateralized loan. In this chapter we will look at the four types of collateralized loans in which the collateral is a bond: repurchase agreement, dollar roll, securities lending, and margin buying.

A collateralized loan is not the only mechanism available to an investor for creating leverage. Derivative contracts are instruments that allow an investor to synthetically create leverage. This is so because a derivative contract allows an investor to obtain greater exposure to a specific bond issuer per dollar invested than the same dollar amount invested in the cash-market instrument. For example, the initial futures margin that an investor must make to obtain a long position in a Treasury bond futures contract creates an exposure to Treasury bonds much greater than the exposure if that initial futures margin were used to purchase Treasury bonds. In the case of an interest-rate swap, consider the fixed-rate receiver’s position. This party is effectively borrowing on a floating-rate basis to obtain exposure to a fixed-rate bond position where the par value of that bond position is equal to the swap’s notional amount. Similarly, there are cash-market instruments that have embedded leverage. For example, an inverse floater position is equivalent to borrowing funds on a floating-rate basis in order to obtain a fixed rate.

REPURCHASE AGREEMENT

A repurchase agreement, or simply repo agreement or repo, is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. The price at which the seller subsequently must repurchase the security is called the repurchase price, and the date that the security must be repurchased is called the repurchase date. Basically, a repurchase agreement is a collateralized loan where the collateral is the security sold and subsequently repurchased.

Suppose that a government securities dealer purchases a 3.125% coupon Treasury note that matures on May 15, 2021 on Tuesday, May 24, 2011. The face amount of the position is $1 million, and the note’s full price is $1,001,545.52. Further, suppose that the dealer wants to hold the position overnight. Where does the dealer obtain the funds to finance this position? Of course, the dealer can finance the position with its own funds or by borrowing from a bank. Typically, the dealer uses a repurchase agreement or “repo” market to obtain financing. In the repo market, the dealer can use the purchased Treasury note as collateral for a loan. The term of the loan and the interest rate a dealer agrees to pay are specified. The interest rate is called the repo rate. When the term of a repo is one day, it is called an overnight repo. Conversely, a loan for more than one day is called a term repo. The transaction is referred to as a “repurchase agreement” because it calls for the security’s sale and its repurchase at a future date. Both the sale price and the purchase price are specified in the agreement. The difference between the purchase (repurchase) price and the sale price is the loan’s dollar interest cost.

Let us return now to the dealer who needs to finance the Treasury note that it purchased and plans to hold for one day. The settlement date is the day that the collateral must be delivered and the money lent to initiate the transaction. Likewise, the termination date of the repo agreement is May 25, 2011. At this point we need to ask, who is the dealer’s counterparty (i.e., the lender of funds). Suppose that one of the dealer’s customers has excess funds in the amount of $1,001,545.52, called the settlement money, and is the amount of money loaned in the repo agreement.1 On May 24, 2011, the dealer would agree to deliver (“sell”) $1,001,545.52 worth of Treasury notes to the customer and buy the same Treasury security for an amount determined by the repo rate the next day on May 25, 2011.2 Suppose that the repo rate in this transaction is 0.08%. Then, as will be explained below, the dealer would agree to deliver the Treasury notes for $1,001,545.52 and repurchase the same securities for $1,001,547.75 the next day. The $2.23 difference between the “sale” price of $1,001,545.52 and the repurchase price of $1,001,547.75 is the dollar interest on the financing.

The following formula is used to calculate the dollar interest on a repo transaction:

Dollar interest = (dollar principal) × (repo rate) × (repo term/360) Notice that the interest is computed using a day-count convention of actual/360 like most money market instruments. In our illustration, using a repo rate of 0.08% and a repo term of one day, the dollar interest is $2.23, as shown below:

$2.23 = $1,001,545.52 × 0.0008 × (1/360)

The advantage to the dealer of using the repo market for borrowing on a short-term basis is that the borrowing rate (i.e., the repo rate) is less than the cost of bank financing. (The reason for this is explained below.) From the perspective of the entity lending funds, the repo market offers an attractive yield on a short-term secured transaction that is highly liquid.

The repo market can be used not only to finance a position in the market but also to cover a short position. For example, suppose that a dealer shorted a bond issue two weeks ago and must now cover the position—that is, deliver the bond issue. The dealer can do a reverse repo (i.e., agree to buy the bond issue and sell it back). Of course, the dealer eventually would have to buy the bond issue in the market in order to cover its short position. In this case, the dealer is actually making a collateralized loan to the counterparty.

There are a number of terms associated with repurchase agreements that are used widely. This market-specific vocabulary is discussed in Chapter 16 where private money market instruments are discussed. It is important to be mindful that the transaction is straightforward. One party is lending money and accepting a security as collateral while the other party is borrowing money and providing collateral to do so.

Credit Risks

Repos should be structured carefully to reduce credit risk exposure. The amount lent should be less than the market value of the security used as collateral, thereby providing the lender with some cushion should the market value of the security decline. The amount by which the market value of the security used as collateral exceeds the value of the loan is called repo margin or, simply, margin. Margin is also referred to as the “haircut.” Repo margin is generally between 1% and 3%. For borrowers of lower creditworthiness and/or when less liquid securities are used as collateral, the repo margin can be 10% or more.

To illustrate the role of a haircut in a repurchase agreement, let us once again return to the government securities dealer who purchases a 3.125% coupon Treasury note and needs financing overnight. Recall that the face amount of the position is $1 million, and the note’s full price is $1,001,545.52. When a haircut is included, the amount the customer is willing to lend is reduced by a given percentage of the security’s market value. In this case, the collateral is 102% of the amount being lent. Accordingly, to determine the amount being lent, we divide the note’s full price of $1,001,545.52 by 1.02 to obtain $981,907.37. Suppose that the repo rate in this transaction is 0.08%. Then the dealer would agree to deliver the Treasury notes for $981,907.37 and repurchase the same securities for $981,909.55 the next day. The $2.18 difference between the sale price of $981,907.37 and the repurchase price of $981,909.55 is the dollar interest on the financing. Using a repo rate of 0.08% and a repo term of one day, the dollar interest is calculated as shown below:

$2.18 = $981,907.37 × 0.0008 × (1/360)

Another practice to limit credit risk is to mark the collateral to market on a regular basis. (Marking a position to market means recording the value of a position at its market value.) When market value changes by a certain percentage, the repo position is adjusted accordingly. The decline in market value below a specified amount will result in a margin deficit. The BMA Master Repurchase Agreement gives the borrower the option to cure the margin deficit by either providing additional cash or by transferring additional securities that are reasonably acceptable to the lender. Suppose instead that the market value rises above the amount required for margin. This results in a margin excess. In such instances, the BMA Master Repurchase Agreement grants the lender of funds the option to give the borrower cash equal to the amount of the margin excess or to transfer purchased securities to the borrower.

Since the BMA Master Repurchase Agreement covers all transactions where a party is on one side of the transaction, the margin maintenance is not looked at from an individual transaction or security perspective but as all repo transactions with the same counterparty.

The price to be used to mark positions to market is defined in the agreement. The market value is defined as one “obtained from a generally recognized source agreed to by the parties or the most recent closing bid quotation from such a source.”

One concern in structuring a repo is delivery of the collateral to the lender. The most obvious procedure is for the borrower to deliver the collateral to the lender or to the cash lender’s clearing agent. In such instances, the collateral is said to be “delivered out.” At the end of the repo term, the lender returns the collateral to the borrower in exchange for the principal and interest payment. This procedure may be too expensive, though, particularly for short-term repos, because of the costs associated with delivering the collateral. The cost of delivery would be factored into the transaction by a lower repo rate that the borrower would be willing to pay. The risk of the lender not taking possession of the collateral is that the borrower may sell the security or use the same security as collateral for a repo with another party.

As an alternative to delivering out the collateral, the lender may agree to allow the borrower to hold the security in a segregated customer account. Of course, the lender still faces the risk that the borrower may use the collateral fraudulently by offering it as collateral for another repo transaction. If the borrower of the cash does not deliver out the collateral but instead holds it, then the transaction is called a hold-in-custody repo (HIC repo). Despite the credit risk associated with an HIC repo, it is used in some transactions when the collateral is difficult to deliver (such as in whole loans) or the transaction amount is small and the lender of funds is comfortable with the reputation of the borrower of the cash.

Another method is for the borrower to deliver the collateral to the lender’s custodial account at the borrower’s clearing bank. The custodian then has possession of the collateral that it holds on behalf of the lender. This practice reduces the cost of delivery because it is merely a transfer within the borrower’s clearing bank. If, for example, a dealer enters into an overnight repo with customer A, the next day the collateral is transferred back to the dealer. The dealer can then enter into a repo with customer B for, say, five days without having to redeliver the collateral. The clearing bank simply establishes a custodian account for customer B and holds the collateral in that account. This specialized type of repo arrangement is called a triparty repo. In fact, for some regulated institutions, for example, federally chartered credit unions, this is the only type of repo arrangement permitted.

The agreement covers the events that will trigger a default of one of the parties (i.e., “events of default”) and the options available to the nondefaulting party. In the case of a bankruptcy by the borrower, the bankruptcy code in the United States affords the lender of funds in a qualified repo transaction a special status. It does so by exempting certain types of repos from the stay provisions of the bankruptcy law. This means that the lender of funds can liquidate the collateral immediately to obtain cash.

Determinants of the Repo Rate

Just as there is no single interest rate, there is no unique repo rate. Repo rates vary from transaction to transaction and across time due to a number of factors. These factors include the following: (1) quality of the collateral; (2) term of the repo; (3) delivery of the collateral; (4) availability of the collateral; and (5) the prevailing federal funds rate. These factors are discussed in detail in Chapter 16.

DOLLAR ROLLS

In the mortgage-backed securities (MBS) market, a special type of collateralized loan has developed because of the characteristics of these securities and the need of dealers to borrow these securities to cover short positions. This arrangement is called a dollar roll, so-called because the dealer is said to “roll in” securities borrowed and “roll out” securities when returning the securities to the investor.

As with a repo agreement, it is a collateralized loan that calls for the sale and repurchase of a security. Unlike a repo agreement, the dealer who borrows the securities need not return the identical securities. Specifically, the dealer need only return “substantially identical securities.” This means that the security returned by the dealer that borrows the security must match the coupon rate and security type (i.e., issuer and mortgage collateral). This provides flexibility to the dealer. In exchange for this flexibility, the dealer provides 100% financing. That is, there is no overcollateralization or overmargin required. Moreover, the financing cost may be cheaper than in a repo because of this flexibility. Finally, unlike in a repo, the dealer keeps the coupon and any principal paid during the period of the loan.

Determination of the Financing Cost

Determination of the financing cost is not as simple as in a repo. The key elements in determining the financing cost, assuming that the dealer is borrowing securities/lending cash, are

1. The sale price and the repurchase price

2. The amount of the coupon payment

3. The amount of the principal payments due to scheduled principal payments

4. The projected prepayments of the security sold (i.e., rolled in to the dealer)

5. The attributes of the substantially identical security that is returned (i.e., rolled out by the dealer)

6. The amount of under- or overdelivery permitted

Let’s look at these elements. In a repo agreement, the repurchase price is greater than the sale price; the difference represents interest and is called the drop. In the case of a dollar roll, the repurchase price need not be greater than the sale price. In fact, in a positively sloped yield-curve environment (i.e., long-term rates exceed short-term rates), the repurchase price will be less than the purchase price. The reason for this is the second element, the coupon payment. The dealer keeps the coupon payment.

The third and fourth elements involve principal repayments—scheduled principal and prepayments. As with the coupon payments, the dealer retains the principal payments during the period of the agreement. A gain will be realized by the dealer on any principal repayments if the security is purchased by the dealer at a discount and a loss if purchased at a premium. Because of prepayments, the principal that will be paid is unknown and, as will be seen, represents a risk in determination of the financing cost.

The fifth element is another risk because the effective financing cost will depend on the attributes of the substantially identical security that the dealer will roll out (i.e., the security it will return to the lender of the securities) at the end of the agreement. Finally, delivery tolerances allowing for a small amount of under- or overdelivery are permitted. In a dollar roll, the investor and the dealer have the option to under- or overdeliver: the investor when delivering the securities at the outset of the transaction and the dealer when returning the securities at the repurchase date. The variance is the amount by which the delivery may deviate from the original trade amount. At one time, the variance permitted could have a significant impact on the effective financing cost. Today, the impact is minimal because for TBA trades of Ginnie Mae, Fannie Mae, and Freddie Mac pass-throughs, the variance is only ±0.01% of the dollar amount of the original transaction agreed on by the parties. No allowance for variance is permitted for specified pool trades.

To illustrate how the financing cost for a dollar roll is calculated, suppose that an investor enters into an agreement with a dealer in which it agrees to sell $10 million par value (i.e., unpaid aggregate balance) of Ginnie Mae 8s at 101 7/32 and repurchase substantially identical securities a month later at 101 (the repurchase price). The drop is therefore 7/32. While under- or overdelivery is permitted, we will assume that $10 million par value will be delivered to the dealer by the investor and that the same amount of par value will be returned to the investor by the dealer. Since the sale price is 101 7/32, the investor will receive in cash $10,121,875 (101.21875 × $10 million). At the repurchase date, the investor can repurchase substantially identical securities for 101, or $10,100,000. Therefore, the investor can sell the securities for $10,121,875 and buy them back for $10,100,000. The difference, which is the drop, is $21,875.

To offset this, the investor forfeits the coupon interest during the period of the agreement to the dealer. Since the coupon rate is 8%, the coupon interest forfeited is $66,666 (8% × $10 million/12). The dealer is also entitled to any principal repayments, both regularly scheduled and prepayments. Since the dealer purchases the securities from the investor at $1017/32, any principal repayments will result in a loss of $17/32 per $100 of par value of principal repaid. From the investor’s perspective, this is a benefit and effectively reduces the financing cost. While the regularly scheduled amount can be determined, prepayments must be projected based on some Public Securities Association (PSA) speed. In our illustration, for simplicity, let’s assume that the regularly scheduled principal payment for the month is $6,500 and that the prepayment is projected to be $20,000 based on some PSA speed. Since $17/32 is lost per $100 par value repaid, the dealer loses $79 due to the regularly scheduled principal payment (17/32 × $6,500/100) and $244 from prepayments (17/32 × $20,000/100).

The monthly financing cost is then

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The financing cost as calculated, 5.27%, must be compared with alternative financing opportunities. For example, funds can be borrowed via a repo agreement using the same Ginnie Mae collateral. In comparing financing costs, it is important that the dollar amount of the cost be compared with the amount borrowed. For example, in our illustration, we annualized the cost by multiplying the monthly rate by 12. The convention in other financing markets may be different for annualizing.

Risks in a Dollar Roll from the Investor’s Perspective

Because of the unusual nature of the dollar roll transaction as a collateralized borrowing vehicle, it is only possible to estimate the financing cost. From our illustration, it can be seen that when the transaction prices are above par value, then the speed of prepayments affects the financing cost. The maximum financing cost can be determined by assuming no prepayments. In this case, the total financing cost would be $244 greater, or $44,712. This increases the monthly financing cost from 5.27% to 5.29%, or 2 basis points. In practice, an investor can perform sensitivity analysis to determine the effect of prepayments on the financing cost.

In addition to the uncertainty about prepayments, the dealer can select the securities to deliver as long as they are substantially identical. However, even among substantially identical securities, there are some pools that perform worse than others. The risk is that the dealer will deliver poorly performing pools.

MARGIN BUYING

Investors can borrow cash to buy securities and use the securities themselves as collateral in a standard margin agreement with a brokerage firm. The funds borrowed to buy the additional securities will be provided by the broker, and the broker gets the money from a bank. The interest rate that banks charge brokers for these transactions is known as the call money rate (also called the broker loan rate). The broker charges the investor the call money rate plus a service charge.

The broker is not free to lend as much as it wishes to the investor to buy securities. The Securities and Exchange Act of 1934 prohibits brokers from lending more than a specified percentage of the market value of the securities. The initial margin requirement is the proportion of the total market value of the securities that the investor must pay for in cash. The 1934 act gives the Board of Governors of the Federal Reserve the responsibility to set initial margin requirements, which it does under Regulations T and U. The initial margin requirement varies for stocks and nongovernment/nonagency bonds and is currently 50%, although it has been below 40%. There are no restrictions on government and government agency securities.

The Fed also establishes a maintenance margin requirement. This is the minimum amount of equity needed in the investor’s margin account as compared with the total market value. If the investor’s margin account falls below the minimum maintenance margin, the investor is required to put up additional cash. The investor receives a margin call from the broker specifying the additional cash to be put into the investor’s margin account. If the investor fails to put up the additional cash, the securities are sold.

SECURITIES LENDING

A security lending transaction involves two parties. The first is the owner of a security who agrees to lend that security to another party. This party is called the security lender or the beneficial owner. The second party is the entity that agrees to borrow the security, called the security borrower. A security lending transaction is one in which the security lender loans the requested security to the security borrower at the outset, and the security borrower agrees to return the identical security to the security lender at some time in the future. The loan may be terminated by the security lender on notice to the security borrower, typically of not more than five business days.

To protect against credit risk, the security lender will require that the security borrower provide collateral. Collateral can take the form of (1) cash, (2) a letter of credit, or (3) a security whose value is at least equal in value to the securities loaned. In the United States, the most common form of collateral is cash. Outside the United States, all types of securities have been used as collateral, including common stock and convertible securities. Typically, if the collateral is a security, it is marked-to-market on a daily basis.

When cash is the collateral, the proceeds are reinvested by the security lender. The security lender faces the risks associated with reinvesting the cash. The income generated from reinvesting the cash is given to the security borrower less an amount retained by the security lender for loaning the security because the fee earned by the security lender is then the difference between the income earned from reinvesting the cash and the amount the security lender agrees to pay the security borrower. The security lender’s fee is called an embedded fee when there is cash collateral. The agreed-on amount that the security lender pays to the security borrower is called a rebate. The security lender only earns a fee if the amount earned on reinvesting the cash collateral exceeds the rebate. In fact, if the amount earned is less than the rebate, the security lender incurs this cost.

When the collateral is a letter of credit or a security, the security borrower compensates the security lender by a predetermined fee. This fee is called a borrow fee, and it is based on the value of the security borrowed. Notice that while the security lender knows what the fee will be in the case of noncash collateral, this is not the case when there is cash collateral. The fee is a function of the performance of the portfolio or security in which the cash collateral is reinvested.

During the period in which the security is loaned to the borrower, there may be an interest payment (dividend payment in the case of stock). The security lender is entitled to a payment from the security borrower equal in amount to any such payment. The payment made by the security borrower to the security lender for this purpose is called a substitute payment or in-lieu-of payment.

A party with a portfolio of securities to lend can either (1) lend directly to counterparties that need securities, (2) use the services of an intermediary, or (3) employ a combination of the first two. If a party decides to lend directly, it must have the in-house capability of assessing counterparty risk. When an intermediary is engaged, the intermediary receives a fee for its services. The intermediary could be an agent (i.e., acts on behalf of a security lender but does not take a principal risk position) or a principal (i.e., takes a principal risk position). Possible agents include the current domestic/global custodian of the securities or a third-party specialist in securities lending.

When cash collateral must be reinvested, a securities lender must decide on whether it will reinvest the cash or use the services of an external money manager. As noted earlier, securities lenders may realize a return on the cash collateral that is less than the rebate.

Comparison to Repurchase Agreements

It is worthwhile to compare a security lending transaction in which the collateral is cash to a repurchase agreement because both transactions represent a secured borrowing. We will do this with an illustration. The parties are as follows:

• Manager X, who is the beneficial owner of security A

• Manager Y, who needs security A to cover a short position

Also suppose that security A is a debt instrument that pays coupon interest.

The following agreement is entered into by manager X and manager Y:

1. Manager X agrees to transfer security A to manager Y.

2. Manager Y agrees to give cash to manager X.

3. At some future date, manager Y agrees to return security A to manager X.

4. Manager X agrees to return the cash to manager Y when manager Y returns security A to manager X.

The economics of this transaction are simple: it is a secured loan of cash with the lender of cash being manager Y and the borrower of cash being manager X. The collateral for this loan is security A. This transaction can be structured as a security lending or a repurchase agreement. No matter what it is called, the economics are unchanged.

If this transaction is structured as a security lending agreement, then

1. Manager X is the security lender (beneficial owner).

2. Manager Y is the security borrower.

3. Manager X invests the cash received from manager Y and at the end of the transaction rebates part of the income earned to manager Y.

4. The amount earned by manager X from security lending is uncertain and, in fact, can be negative.

5. Manager Y pays manager X any interest income that manager X would have received from the issuer of the security.

6. At some future time, manager X requests the return of security A and returns the cash collateral to manager Y.

If this transaction is structured as a repurchase agreement, then

1. Manager X is the seller of collateral or, equivalently, the borrower of funds using security A as collateral.

2. Manager Y is the buyer of collateral or, equivalently, the lender of funds.

3. Manager X invests the cash received from manager Y and at the repurchase date pays interest to manager Y based on the repo rate.

4. The amount earned by manager X from the repurchase agreement is uncertain and, in fact, can be negative.

5. Manager Y pays manager X any interest income that manager X would have received from the issuer of the security.

6. At the repurchase date, manager X buys back security A from manager Y at the repurchase price (which includes interest).

Whether the transaction is a repo or reverse repo depends on the perspective of the parties, as discussed earlier in this chapter. Notice that unlike a repurchase agreement, which has a repurchase date—which can be rolled over—there is no repurchase price in a security lending transaction.

KEY POINTS

• A repurchase agreement is the sale of a security with a commitment by the seller to buy the security back from the purchaser at a specified price on a designated future date.

• Repo margin or haircut is the amount by which the security’s value exceeds the loan amount.

• A dollar roll is a specialized type of collateralized loan particular to the MBS market.

• Investors can borrow cash to buy securities and use the securities themselves as collateral with a standard margin agreement with a brokerage firm.

• A securities lending transaction involves one party lending a security and accepting collateral while another party borrows a security and provides collateral.

• In order to induce the security borrower to provide cash as collateral as opposed to some other form (e.g., another security or letter of credit), the security lender pays the security borrower a prespecified fee called the rebate rate.

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