U.S. Treasury Fails And The Repo Market: Cause For Concern?

by: Invesco US

Summary

We thought it worthwhile to evaluate whether the volume of US Treasury fails warrants concern in the repo market.

Extreme demand for specials can result in these specific securities trading at a negative rate, as happened recently with the 10-year US Treasury note.

Recent demand for the 10-year US Treasury note was a key driver in the surge of US Treasury delivery fail volumes, the largest since 2008.

Demand for the 10-year US Treasury note drove a recent headline-making surge in delivery fail volumes

By Laurie Brignac, Marques Mercier, Brian Schneider, Justin Mandeville and Rob Corner. Posted on Expert Investment Views: Invesco US Blog.

A recent article in The Wall Street Journal raised questions regarding "failures in Treasury repurchase agreement transactions" and their impact on trading conditions.1 We at Invesco Global Liquidity thought it worthwhile to describe what happened and evaluate whether concern is warranted.

What is a repurchase agreement?

A repurchase agreement (repo) is a financial transaction in which one entity lends cash and purchases an asset as collateral, while the other party simultaneously borrows cash and agrees to repurchase the same asset at a specified future date. For example, a money market fund lends cash to a broker-dealer in exchange for securities as collateral and a promise that the broker-dealer will buy the securities back on a specific date. The money market fund earns a market rate, and the broker-dealer gets funding.

A general collateral (GC) repo is backed - or collateralized- by high-quality assets that are close substitutes for one another. In many cases, GC repos are backed US Treasury securities, US agency securities, or US agency mortgage-backed securities. GC repos normally pay a market rate near the Fed Funds rate or Libor.

"Specials" driven by demand

In some repo transactions, an entity may want a specific security as collateral. Repo rates for these specific securities are often lower than GC repo rates due to high demand for a particular security. As a result, these securities trade "special" in the repo market. As is often the case, extra demand for new-issue US Treasury securities can lead to those securities trading special in the repo market.

When demand for specials is extreme, the repo rate for these specific securities can trade at a negative rate. This was recently the case, when the repo rate to borrow the 10-year US Treasury note reached a punishing -3.15%2 versus an average rate of 0.46% for GC repo Treasury collateral.3 The unusually strong jump in demand for the 10-year US Treasury note was most likely caused by investors trying to close out a significant amount of short positions, as yields have bounced off the lowest level in three years.4

Fails are a common occurrence

In some cases, overwhelming demand for specials results in insufficient supply that prevents delivery of a specific security to buyers. This is called a failed trade, or delivery fail. Treasury fails aren't new. In fact, delivery fails in the US Treasury market are a common occurrence, averaging $49.2 billion per week from January 2009 to December 2015.4

But recent demand, or specialness, for the 10-year US Treasury note was a key driver in the surge of US Treasury delivery fail volumes, which totaled $456 billion the week ended March 9.4 Because this is the largest volume of US Treasury fails since October 2008, it made headlines in the financial press.4

No impact on the GC repo market

Fails of individual specials don't impact the normal functioning of the GC repo market, because the collateral for GC repos can be close substitutes for one another. In this instance, the high repo cost of the 10-year US Treasury note in the specials market excluded it from being used as collateral in a GC repo. So, while failure to deliver the 10-year US Treasury note may have impacted the repo market for specials, it didn't affect the more broad-based GC repo market, and is therefore not a cause for concern, in our view.

Fails eventually clear as supply and demand forces rebalance, or as prices and yields adjust. The March 15 settlement of $20 billion in new supply of the 10-year Treasury note alleviated much of the pressure on that note, normalizing the rate the security trades at in the repo market.5

Invesco Global Liquidity

Repos are a vital short-term investment for the money market fund industry as a whole, and Invesco's money market funds are a large participant in the repo market as a cash investor. Importantly, as previously mentioned, delivery fails of US Treasury securities don't impact GC repos, because a number of liquid securities - not just a specific security - can satisfy the collateral required for GC repos.

Invesco Global Liquidity enters into repos only with high-quality counterparties that pass a rigorous credit research process and are monitored on a daily basis. Repo collateral remains in our account at the custodian until the transaction unwinds at maturity.

1 Source: The Wall Street Journal, "Repo Failures at Highest Level Since 2008," March 21, 2016

2 Source: Jefferies, March 15, 2016

3 Source: Bloomberg LP, January 4, 2016 - March 20, 2016

4 Source: Bloomberg LP

5 Source: Treasury Direct, March 9, 2016

Important information

A US agency security is a low-risk debt obligation issued by US government-sponsored entities and other federally related bodies.

The fed funds rate is the rate at which banks lend balances to each other overnight.

Libor (London Interbank Offered Rate) is a benchmark rate that some of the world's leading banks charge each other for short-term loans.

Shorting is a strategy involving selling a stock on the expectation that its price will decline so that the stock can be bought back at a lower price to make a profit.

Yield is the income return on an investment.

If the seller of a repurchase agreement defaults on its obligation or declares bankruptcy, delays in selling the securities underlying the repurchase agreement may be experienced, resulting in losses.

Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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US Treasury fails and the repo market: Cause for concern? by Invesco Blog