Not Another Money Market Fund!
by Jane Kawar, Head of Product Development, RBS Asset Management Limited
In this article, Jane Kawar, Head of Product Development at RBS Asset Management Limited, the Royal Bank of Scotland’s active cash and fixed income asset management business, explains tri-party reverse repurchase agreements (’repo’) which can provide higher returns than typical money market funds, but still focus on capital preservation.
Money market fund managers are having a tough old time eking out a decent yield at the moment. Historically low interest rates, bank downgrades, and regulatory and rating agency constraints have all helped contribute to a lacklustre yield environment.
Of course, maintaining a stable net asset value and providing investors with daily liquidity are the most important attributes of a money market fund and yield should be seen as tertiary. However, current yield conditions should be causing portfolio managers to look at different sources of return with a view to expanding their product offering to include higher yielding products that don’t compromise capital preservation. Tri-party reverse repurchase agreements or ’repo’ offer this potential.
What is a repo?
In simple economic terms repo can be considered equivalent to secured lending to a bank or other financial institution. Like fixed term deposits, repo aims to protect your initial capital, your return is known at the start of the transaction and you enter into set maturities, e.g., daily, weekly, monthly or yearly. So for example, you could enter into a 1 month £ repo for £100m. At the start of the transaction the counterparty would let you know the annual % return you would receive at maturity, e.g., 1.00%. At the end of the repo term you would receive £100,002,739.73 (i.e., £100m * 1.00%/365).
Fixed term deposits are unsecured lending. This means that in many cases if the counterparty defaults an investor becomes an unsecured creditor to the defaulted institution and is paid according to the capital structure and recovery value. Repo provides an additional layer of protection for the investor not achievable through traditional deposits (even considering deposit insurance which can be limited) as it is backed by a diversified pool of collateral held by a third party, Euroclear. This collateral could include equities or bonds of differing credit quality and maturity. Over-collateralisation is applied to each of the underlying assets to provide an additional layer of protection.
What is over-collateralisation and margin?
Over-collateralisation is the provision of additional collateral and is there to protect the repo holder from making a loss. For example, a £100m repo that is backed by securities with a 10% over-collateralisation level would result in £110m of such securities being transferred to the Euroclear account. The underlying securities are valued daily by Euroclear and margin is transferred to ensure that the value of the securities always equals £110m.
What do returns look like?
If you are able to give up the daily liquidity, term repo may allow you to earn additional yield compared to traditional money market funds or term deposits. Indicative gross returns as at end May 2012 are shown in Figure 1 (see next page).