Filter insights on this page
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. The volatility and market uncertainty that resulted from the mini-Budget also weighed upon funding markets, particularly for shorter dated trades as can be seen from the achieved spreads below. Note that during the fourth quarter of 2022 no repos were traded with a 12m tenor so the chart reflects the previous quarter’s value.
Capabilities
Media type
Themes
The secondary impact of the mini-Budget crisis centred around collateral and the velocity of movement; rather than a lack of balance sheet for repo funding (a la March 2020). Yet, the difficulties around collateral substitutions and settlements did in many cases prompt a review by individual banks’ credit officers, resulting in a temporary reduction or hiatus in repo balance sheet provision in some cases. Once these reviews were completed balance sheet availability opened up again – some with the addition of haircuts to provide additional protection to the bank. Of course, the momentous lack of certainty in the future path of interest rates also impacted the typical repo spread to SONIA as trading a fixed rate forced the banks to take a conservative view on where yields could reach.
Regions
A key feature of many LDI strategies is capital efficiency, allowing schemes to meet their liability risk management objectives whilst targeting an appropriate level of growth to close any funding gap or create a funding surplus.
This capital efficiency (or leverage) is typically delivered using swaps, gilt repo, or other gilt derivatives. This note focusses on gilt repo, explaining what it is and providing an update on the latest themes and trends in this sub-sector of the market.
What is repo?
Gilt repo (short for sale and repurchase agreement) can be thought of as secured borrowing. We borrow money from a bank and provide high quality security in the form of gilts to minimise the borrowing cost. This is similar in concept to a mortgage, where the security of our house helps minimise the cost. In practice, and as the longhand name suggests, we sell our gilts to the bank (raising cash in the process) and agree to buy them back for a fixed price in the future. The cash we raise is used to buy additional gilts and the act of fixing the repurchase price upfront means we retain economic exposure to the gilts we pass to the bank. This is important as it is this economic exposure that is matching our pension scheme’s liabilities.
Gilt repo is typically a short-term borrowing arrangement with terms ranging from overnight to 12 months. This means that our borrowing needs to be rolled over regularly and it is important to consider how we manage this roll risk. There are several key roll risk mitigants as follows:
- Pro-active management of roll dates to avoid obvious market pinch points (year end, national holidays, political milestones etc.) and diversify roll points throughout the year.
- Maximise access to the market. As with the mortgage market, an individual bank’s appetite to lend and lending criteria can change from one month to the next. The more banks you have access to, the more chance there is of being able to roll the borrowing over at a competitive rate.
- Maximise the wider LDI toolkit. Ensure a portfolio has access to other forms of leverage or funding such as gilt total return swaps, gilt futures and traditional interest rate and inflation swaps.
Gilt repo pricing
Gilt repo borrowing costs are quoted as a spread to an overnight interest rate (SONIA – Sterling Overnight Index Average). As an investment manager, we are focussed on minimising this spread for clients, with the underlying SONIA rate being highly correlated to the Bank of England base rate.
Gilt repo pricing has been very low for several years, largely due to the high volume of liquidity injected into the market by the Bank of England’s quantitative easing (QE) programme. With this in the process of being reversed in the form of quantitative tightening (QT), we have seen repo costs increase during the first half of 2024, albeit, coming from a low base at SONIA plus 0.10-0.15% they remain below the long-run average of SONIA plus around 0.25%. The chart below illustrates the repo pricing we have achieved across our book for 3, 6, 9 and 12 month tenors during each of the last four quarters.
Repo spread to SONIA
Source: Columbia Threadneedle Investments
An interesting feature of markets over recent years has been the material benefit achievable by carefully selecting which bond(s) to pass to a bank in a repo transaction. Any bonds in high demand (often referred to as “special”) attract significantly lower repo costs, often SONIA minus a spread rather than SONIA plus a spread. Special bonds have typically been sub-20-year bonds as these have been locked up on the Bank of England’s balance sheet. However, now these bonds are being sold back to the market through QT this benefit is diminishing.
Throughout the remainder of this note we examine different approaches to repo and discuss their relative pros and cons.
Bilateral repo
This is the most common form of repo and therefore where the lowest costs and highest volumes can be found. It involves a direct “bilateral” transaction with an individual bank and is governed by an industry standard Global Master Repo Agreement (GMRA), which also sets out associated collateral terms. The repo is collateralised daily so, if the value of the bonds held by the bank moves relative to the value of borrowed cash, the difference is trued up daily (subject to a minimum transfer amount or MTA). Historically, bilateral repo has been collateralised using gilts but during and following the gilt crisis it has become common to additionally permit cash collateralisation of repo. This means that cash received from clients can be passed straight through as collateral rather than having to be transformed into gilts first.
We have umbrella GMRAs in place with 23 banks providing wide ranging market access and allowing clients to leverage off a centrally agreed set of trading terms, managed and maintained by us.
Sometimes a bank will haircut the gilts used in a repo and so you must pass £101 of bonds to them to borrow £100 of cash. This varies from bank to bank, and it is important to consider the all-in trade terms. For example, it may be advantageous to trade with a small haircut if the cost is attractively low rather than simply ruling out any trade terms with haircuts.
The advantages of bilateral repo are that typically volumes are high, costs are low, haircuts are low or zero (typically up to 2%) and market access is straightforward. The only counterpoint is that liquidity can diminish in a crisis, and therefore costs could rise slightly. However, bilateral repo can be thought of as a good base case barometer for other forms of repo, so if bilateral repo costs rise and availability falls, there is a good chance that other forms of gilt repo will experience the same.
Centrally cleared repo
Akin to the central clearing of swaps, repo terms are agreed with an individual bank but both sides of the trade are then passed to a central clearing house, often referred to as a central counterparty or CCP. Investors then face the CCP rather than then individual bank.
The advantages of this approach are that it creates a central liquidity pool, provides relatively easy access to a wide group of banks and it allows the banks to obtain balance sheet netting more easily, which reduces the impact on their balance sheet, in theory reducing the cost of the repo.
However, there remain several prohibitive disadvantages, which have served to severely limit take-up of this form of repo. Firstly, Initial margin requirements (akin to a haircut) are extremely onerous and can be up to 50%. The additional operational costs of clearing mean that in most cases costs/spreads are higher than bilateral repo except where a bank receives a netting benefit. To date, take-up has largely been limited to the interbank market which typically trades very short-dated repo. This means that liquidity tends to be concentrated in sub-2-week repo, whereas pension schemes would normally trade longer dated repo up to 12 month repo to minimise roll risk, complexity, and costs. Lastly the operational set up itself is challenging and time-consuming and these expenses increase the hurdles to set-up thereby restricting access to only the largest entities.
Bank of England repo facility
This will be a facility aimed at non-bank financial institutions (e.g. investment managers, LDI funds and insurance companies) to allow them to transact gilt repo directly with the Bank of England (BoE), basically borrowing off the BoE’s balance sheet. It is intended to be a contingent facility to be used in times of market stress when repo availability may be impaired through traditional channels.
We see this as a useful tool to have in the toolbox to ensure we maximise market access for clients in all scenarios. However, it is likely to be intentionally priced at a premium and so would only be used as a contingency. It remains under development and so is not currently live. There is a risk that it does not use existing trading platforms which may increase operational complexity when setting the facility up and transacting.
The BoE has been engaging with the market on the design and functionality of the facility and we have had several direct conversations with them as part of this process.
Peer-to-peer or indemnified repo
Originally designed to remove or disintermediate banks from repo transactions, connecting cash providers directly with cash borrowers (e.g. corporates or money market funds with LDI). This created challenges as LDI funds and pension schemes typically have no credit rating, making due-diligence and regulatory requirements harder to meet. Most peer-to-peer repo has now morphed into indemnified or guaranteed repo where the cash borrower still faces the cash provider directly, but the transaction is guaranteed by a bank (for the benefit of the cash provider). There are various providers/platforms for indemnified repo, all offering something slightly different in terms of set-up and universe of cash providers.
In theory, cutting out the bank middleman should reduce borrowing costs, but the guarantee is not free and can offset this saving, and haircuts are typically larger than for traditional bilateral repo. The market is in its infancy and volumes are very low. We expect development to accelerate in the US to provide a credible alternative to mandatory clearing.
Disintermediating the banks also gives rise to a disadvantage in that the bank’s function in a repo transaction is to manage and own the tenor mismatch that exists between lenders and borrowers. Cash providers want ready access to their cash, whilst pension schemes want to lock into borrowing for longer periods of time to create certainty of cost and minimise roll-risk. Removing the bank from the process means that overnight and 1 to 2 week repo are currently the mainstay of the very small peer to peer market.
Credit repo
Whilst beyond the core scope of this note, it is worth mentioning credit repo as interest in this has accelerated following the gilt crisis. Credit repo involves passing corporate bonds to a bank as security for lending, instead of gilts (technically via the same sale and buyback). The higher risk associated with corporate bonds relative to gilts means that borrowing costs and haircuts are generally higher. Borrowing costs could be 0.1-0.4% higher and haircuts are typically 5-10%. This higher cost means credit repo is a useful contingency tool to have in the toolkit but one that you would typically use in a crisis and for a short period, rather than in perpetuity. It should also not be relied upon as bank appetite to do credit repo varies, as was proven during the credit crisis of 2007-08 when the credit repo market largely vanished overnight. It should be noted that, just as in the gilt market, there are bonds that are in high demand, the same is true of the corporate bond market – leading to opportunities to repo ‘special’ and obtain superior pricing.
What is next?
The advent of mandatory clearing of repo in the US on 30th June 2026 has prompted some to suggest that it is the next development in the UK. However, the reality is that the markets are very different and as such any mandatory clearing requirement would be years if not a decade away. Client repo trading in the US is largely overnight or sub 1-week and a reasonable portion is already centrally cleared. Meanwhile centrally cleared repo in the UK remains largely confined to interbank transactions for the time being with high haircuts and operational costs being prohibitive.
Conclusion
For a traditional LDI client, the most efficient and cost-effective way of accessing funding remains the bilateral repo market. As costs or spreads approach the long-term average, it is vital to ensure access to a wide range of counterparties under different jurisdictions to take advantage of competitive advantages in pricing various tenors. This is of higher importance than setting up alternative routes such as centrally cleared repo. Whilst indemnified repo will become more attractive as repo spreads increase, the various solutions are in their infancy and need to further develop both their platforms and liquidity to become a viable alternative and part of the daily toolkit (note it would only form a portion of and not replace other repo markets within the framework). The prospect of the BoE repo facility is positive, and Columbia Threadneedle Investments will continue to engage with the BoE as their scheme develops.
Finally, where portfolios hold corporate bonds directly (rather than via a fund), it is worth considering adding credit repo to the toolkit. Although this should be thought of as a contingency tool it could serve to help maintain hedging in a crisis and/or avoid the sale of corporate bonds.
If you would like to discuss any of these matters further, please contact your client representative. We would also draw you attention to our quarterly repo market update notes, which provide colour on market conditions and pricing.
