Inflationary pressures and the response functions of central banks took centre stage at the beginning of the fourth quarter of 2021. Across the US and Europe, rhetoric moved from inflation being transitory to perhaps being stickier than anticipated, thus bringing forward potential rate hikes and tapers to quantitative easing programmes. In the UK, the Bank of England’s (BOE) Monetary Policy Committee (MPC) swerved a fully priced in rate hike in November due to lags in data and being cognisant of the dangers of moving too soon. Yet all this confidence was predicated on the successful vaccine rollout and the continued opening up of economies boosting consumer spending. At which point the Omicron variant intervened. It is to date the most transmissible and highly mutated version of Covid-19, prompting rapid border closures and the re-implementation of restrictions across the globe. As it spread so fast, there was little information at the outset. However it quickly became clear that, although more highly infectious re-infecting those who had already suffered from Covid-19 and bypassing vaccination protection, its symptoms were far less severe, particularly for those who had been vaccinated. While restrictions remained in place throughout the remainder of the fourth quarter, hospitals were not overwhelmed in terms of intensive care beds, but rather were suffering through staff isolation requirements. Despite the uncertainty, the MPC decided to proceed with its pre-Christmas ‘Scrooge’ hike, raising the UK base rate by 0.15% in mid-December.
The market’s view of where long-term rates could move to in the future is encapsulated in forward rates. The chart below shows where the six-month SONIA swap rate is currently (spot) and at various forward rates out to five years. Interestingly, whilst the forwards anticipate a rapid level of tightening, this peaks at the 2 year point and then retraces from there. The one year forward rate has risen by 0.54% over the quarter.
Six month SONIA rate
Repo rates are expressed relative to SONIA, and the chart below displays the average repo rates that we have achieved over the past four quarters for three, six, nine and 12 month repos, shown as a spread to average SONIA levels at the time. Despite the change in rhetoric and the base rate hike, monetary conditions presently remain easy with little change in spreads to SONIA, despite year-end balance sheet window dressing.
Spread to SONIA
Source: Columbia Threadneedle Investments, as at 31st December 2021
Repo conditions remain favourable for those seeking leverage, reflected in the wide availability of balance sheet and the spreads displayed above. However, it is clear from the graph that the differential between the 3 and 12 month numbers warrants further investigation. As regards 3 month repo, the various shocks to the market and rapid changes in expectations for UK rate hikes led to significant intra-day volatility. Where SONIA drops by 0.15% on the day of the foiled rate hike, the move is not necessarily reflected in adjusted repo rates, but the converse is true when the market rises. This can result in anomalous pricing as a spread to close of business SONIA levels. Secondly, repo pricing tends to be more expensive over year-end. For a long tenor repo this cost is spread across the term of the repo, yet for short-dated repo such as 3 months it becomes a greater factor. Excluding the anomalous results, the average spread to SONIA for 3 month repo would be 0.05%. This is consistent with, yet slightly higher than, previous quarters reflecting the year-end turn. Looking at the compression in 12 month repo, this is a consequence of favourable positioning by a few key banks with a strong preference for this tenor, as well as greater use of ‘special’ bonds for repos of that tenor. Typically, in Q4 we see elevated repo levels as banks close their books early for year-end, and demand pushes up pricing. This only occurred at the margins and with certain banks this year due to the liquidity available within the system. In fact, it became much harder to place cash than borrow from banks going into the year-end.
Bilateral repo remains the optimal market access route for liability hedging investors. This is especially true at times such as now where the cost of bilateral repo is so low and thus there is little room for cleared repo to reduce it further. This has served to put a dampener on take-up of alternative repo sources and consequently volumes remain low in such routes as peer-to-peer, direct repo and centrally cleared repo. Electronic trading however is swiftly becoming the norm due to operational and pricing efficiencies. Our repo activity is now entirely managed via electronic platforms, bringing resource benefits to both our clients and our counterparties.
Repo funding generally remains cheaper for creating leveraged exposure to gilts over the lifetime than the equivalent total return swap (TRS) and so continues to be used within our LDI portfolios. However, pricing for total return swaps can be very bond specific and, where the bank counterparty can obtain an exact netted position, the rate can be extremely competitive. TRS can be longer dated, with maturities ranging from one to three years and even five years, as compared to repo which typically vary in term from one to 12 months. Hence, TRS can be beneficial for locking in funding costs for longer and for minimising the roll risk associated with shorter-term repo contracts. On the other hand, repo facilitates tactical portfolio adjustments more easily and tends to be slightly cheaper. We ensure portfolios have access to both repo and TRS for leveraged gilt funding, so we can strike the right balance between cost, flexibility and minimisation of roll risk. It is essential to maintain a range of counterparties to manage the funding requirements of a pension fund. We now have legal documentation in place with 22 counterparties for GMRA (Global Master Repo Agreement) and 23 counterparties for ISDA (International Swaps and Derivatives Association) and more are being negotiated.
Indicative current pricing shows leverage via gilt TRS for a six-month tenor pricing at an average of 0.02% higher than repo (on a spread to six-month SONIA), although this is very bank dependent and indicative quotes provided can be much wider. Another way to obtain leverage in a portfolio is to leverage the equity holdings via an equity total return swap. An equity TRS on the FTSE 100 (where the client receives the equity returns) would indicatively price around 0.21% higher than the repo (also as a spread to six-month SONIA). However, this pricing can vary considerably from bank to bank and at different times due to positioning, which gives the potential for opportunistic diversification of leverage.
SONIA – Sterling Overnight Index Average
