Repurchase agreements, or repos, in many ways serve as the underlying plumbing for financial markets by providing a key source of liquidity. A deeper understanding of these building blocks of short-term strategies may also help improve returns.

Repos are a form of short-term funding in which dealers sell securities to investors, usually on an overnight basis or predetermined term, and agree to buy them back the next day with additional interest or premium due to the lender of cash. While repos were in the spotlight during the financial crisis for accounting irregularities, their importance to the daily functioning of global financial markets remains steadfast and evident. We see the need for a renewed focus on repos today for the opportunity they present to invest cash while typically receiving high quality collateral in return, often U.S. Treasuries. Frequently overlooked, the repo market offers investors a real-time barometer of the health of liquidity in global markets and highlights the true cost of capital and funding for institutions and investors alike.

Short-dated assets like repos look compelling

In an aging expansion marked by inverted yield curves in the U.S., the return of market volatility, and anemic average yields for many equity dividends, investors are looking for options that provide acceptable risk-adjusted return potential amid an uncertain global economic outlook. We think short-dated assets look compelling in this economic environment, and specifically favor repos as a foundation of our diversified portfolios given their attractive yield (as we discuss in more detail below), minimal price volatility relative to other securities, and the investment opportunity that a flat yield curve is providing by minimizing interest rate exposure. Moreover, such overnight and short-dated maturities can provide dry powder to take advantage of dislocations that may arise in other sectors of the financial markets late in this economic cycle.

While we believe short-dated rates in general look attractive, rates in the repo market continue to exceed those of many asset classes on a risk-adjusted basis: Overnight repurchase yields, currently around 2.50%, are outyielding U.S. Treasuries with maturities out to 10 years (see chart).

The figure is a line graph of the PIMCO overnight repo yield, along with yields for two-year, five year and 10-year Treasuries, for the period December 2018 to April 2019. The graph shows how repo yields in late March spiked to about 3.25%, before dropping in late April to about 2.5%, about the same as the 10-year Treasury yield, compared with about 2.3% for the five-year and the two-year. Over the five-month period, repo yields usually were the lowest yield, aside when they briefly spiked in January, February and March.

Why would repo yields be higher than those of nominal Treasuries? It’s because many market participants are expecting the Federal Reserve to cut rates over the next one to two years, and U.S. Treasury yields have recalibrated lower recently as a result. If you believe a recession may be right around the corner, longer-duration assets are likely your allocation of choice.

However, if the Fed manifests its stated cautious approach by keeping rates on hold for the foreseeable future, as we expect, then exposure to front-end strategies with a foundation in repos is an attractive proposition versus other alternatives which open investors to greater market volatility. Recent incremental market needs for financing assets, predominantly Treasuries, have also supported higher yields in the repo market, now currently trading above the Fed’s benchmark rate for interest on excess reserves (IOER) of 2.40%.

Not all repo approaches are created equal

Not all repo approaches yield the same results, and we see two key ways for investors to seek value in the repo markets:

  1. Seek competitive execution. Investment managers often act as both lenders and borrowers of cash at times, which encourages dealers to make competitive markets for them on both sides. This can potentially provide a competitive advantage over traditional money market funds that act as lenders only and may not benefit from the dealer’s incentive to step up yield offers to win the business. Competitive execution by the investment manager helps capture these higher yields, which can be passed on to investors.
  2. Look for high quality collateral and operations. The method for receiving collateral on repurchase agreements may also provide potential benefits (or drawbacks). We think a framework in which the investment manager places collateral into a custody account on behalf of clients, rather than having it held at a third-party custodian (as with most 2a-7 money market funds), not only offers better protection of collateral; it also may potentially earn a higher rate.

Although repos benefit from overcollateralization relative to the proceeds lent, like all investments, repos have risks – most notably counterparty risk. And just as clogged or leaky pipes can wreak havoc on a home, disruptions in the repo market can quickly turn into an expensive problem if not addressed, as markets learned during the “run on repos” leading up to the financial crisis. While the media and market participants quickly moved on to more exciting topics once repo markets had calmed, we think they warrant ongoing attention.

Investor takeaways

For investors, the race is on to find income with minimal volatility. With yields that continue to exceed those of U.S. Treasuries with maturities out to 10 years, overnight repos deserve attention.

An active approach founded on a thorough understanding of what drives movements in the repo markets may help investors optimize the attractive and changing dynamics of de-risking higher-risk portfolios into short term investments.

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The Author

Jerome M. Schneider

Head of Short-Term Portfolio Management

Tina Adatia

Fixed Income Strategist

Kenneth Chambers

Fixed Income Strategist

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Disclosures

London
PIMCO Europe Ltd
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London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
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Milan
PIMCO Europe GmbH - Italy
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+39 02 9475 5400

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PIMCO (Schweiz) GmbH
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Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

All investments contain risk and may lose value. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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