Shortage of Treasuries Stresses Repo Market

Tuesday, April 14, 2015

A shortage of high-quality bonds is disrupting the $2.6 trillion U.S. repurchase agreement market, the Wall Street Journal reports. These short-term loans, also known as repos, provide liquidity in the financial system, and the shortages “are amplifying price swings in government bonds and related debt markets at a time when many investors are reshuffling their portfolios around new interest-rate expectations, following a period of low volatility.” The impact has been manageable, according to traders quoted in the article, but “the broad concern is that scarcity in repos will pressure rates and could complicate efforts by the Federal Reserve to lift interest rates when the time comes.”

The GFOA best practice, Monitoring the Value of Securities in Repurchase Agreements, points out that an important factor in managing the risk of default in repurchase transactions is the valuation of the purchased securities. For the term of the repo agreement, it is common practice for the counterparty to deliver purchased securities to the investor in a total value amount (market value plus accrued interest) that is equal to the investor’s investment plus a margin percentage. The margin percentage, typically 102% for Treasury and GSE securities, protects the investor from a decline in the price of the purchased securities during the time the repo transaction is in effect. The value of the securities must be monitored frequently to insure the market value remains at least equal to the invested amount plus margin percentage in case of default of the counterparty. If the value of the purchased securities falls below the invested amount plus margin percentage, then the counterparty is required to deliver additional securities to the investor upon their request. The frequency of the valuation depends on several factors:

  • • The maturity of the purchased securities, since longer maturities have greater price volatility;
  • • The security types, since certain securities have greater price volatility;
  • • Market volatility; and,
  • • The margin percentage that is required by the investor; the lower the margin percentage, the more frequent the valuation of the purchased securities.

Because the investor may need to liquidate the purchased securities in the secondary market in the event the counterparty defaults on the repurchase agreement transaction, GFOA recommends that government entities establish a policy and procedure for monitoring the value of the purchased securities in a repo transaction to insure that it does not drop below the value of the repo investment plus any required margin percentage. For maximum protection, government entities should value the purchased securities in their repo transactions to their current market price evert dat. At a minimum, the purchased securities should be valued weekly, whenever there is a major increase in rates or market volatility is high; or whenever a coupon and/or principal payment on the purchased securities is wired back to the counterparty.

For more information on repos, see the GFOA best practice, Establishing a Policy for Repurchase Agreements, which defines the kinds of repos, outlines the benefits and risks of using them, and suggests strategies for mitigating the risk.