Portfolio Manager Commentary
Overview, strategy, and outlook: As of January 31, 2014
Developments in the repurchase agreement markets
In our August 2013 commentary, we discussed recommendations issued in June for new bank capital ratios and the unfavorable effect they were having on the repurchase agreement (repo) markets, at least from our vantage point.
In an attempt to rein in balance sheet leverage, the Basel Committee on Banking Supervision, a group of global banking authorities, recommended the supplementary leverage ratio, which required banks to hold additional capital on a non-risk-adjusted basis. Unlike the Tier 1 risk-adjusted capital ratio, the total leverage exposure calculation of assets did not give weighting to risk, so all assets received the same weighting. The initial recommendation also included some assets and other exposures that might ordinarily be off a bank’s balance sheet under accounting standards.
Under current accounting rules, certain repo transactions with the same customer and terms may be offset, or netted, for financial statement accounting purposes and therefore do not increase, or gross up, the size of a bank’s balance sheet. The June proposal for what was to be included in a bank’s assets for purposes of calculating the supplementary leverage ratio would have disregarded this accounting convention and presented the asset (reverse repo) and the liability (repo) on a gross basis, thus increasing the denominator for the purposes of this calculation.
Rather than raise capital against a relatively low-margin book of business, the banks chose instead to shrink their low margin assets, including repos. This had significant implications for the repo market: After being fairly stable throughout 2012, the repo market shrank from $2.7 trillion at the end of 2012 to $2.2 trillion a year later, with most of the drop occurring in the last part of 2013, after the announcement of the Basel III recommendations in June.
Securities financing transactions by primary dealers
Sources: JPMorgan Securities and the FRBNY. Data series represents all primary dealer transactions categorized as “securities out.” This number is greater than the total repo number but captures repo-like securities financing transactions by primary dealers. Data from January 2012 through March 2013, adjusted to approximate new reporting method that took effect on April 1, 2013.
Past performance is no guarantee of future results.
On January 12, 2014, the Basel Committee issued revised recommendations that addressed some of the concerns of market participants, including two changes that might benefit the money markets. Once again, netting of repo and reverse repo transactions will be allowed under certain circumstances, and off-balance-sheet items being brought on balance sheet for the purposes of the supplementary leverage ratio calculation may receive different risk weightings. These changes should benefit the lower risk, lower return businesses such as repo and government securities dealing.
Not all is golden, however. These are recommendations of the Basel Committee, but U.S. banking regulators may yet choose to adopt more stringent standards for U.S. banks. Banking regulators see the availability of cheap wholesale funding as one of the root causes of the recent financial crisis, and repo is at the heart of the wholesale funding market. We also know that they continue to be concerned about other risks posed by the repo markets, such as the knock-on effects of a fire sale of repo collateral in the event of a default. These concerns are not without foundation, and the Fed, in particular, continues to promote reforms in this market; we think it’s likely that shrinking the repo market is one of the reforms they have in mind. So, despite the welcome news these latest Basel recommendations present, we do not look for the repo market to increase in size anytime soon.
Viva Las Vegas!
The Structured Finance Industry Group (SFIG), an industry association, held its inaugural conference in Las Vegas January 21–24, 2014. The SFIG has a large membership, drawing professionals from credit rating agencies, issuers, dealers, the investing and legal communities, and other participants in the structured finance marketplace. With 5,500 attendees, this conference is the largest capital markets conference in the world; but, for comparison purposes, the World of Concrete convention held at the same time had more than 50,000 attendees!
Regulators were front and center at the SFIG conference. The two keynote speakers were Michael Stegman, counselor to the secretary for Housing Finance Policy of the U.S. Department of the Treasury, and Christopher Cox, former chairman of the Securities and Exchange Commission (SEC); Senate Majority Leader Harry Reid opened the conference with a broadcast message. In addition to representatives from the Treasury and the SEC, attendees also included employees of the Federal Reserve (Fed), the Federal Deposit Insurance Corporation, and the Consumer Financial Protection Bureau. In a sign of the times, many of the technical and third-party vendors were focused on compliance and portfolio monitoring.
The tone for the conference was cautiously optimistic. Regulators, issuers, and investors all agree that structured finance is an important avenue for the growth and functionality of our economy. However, while some proposed regulations have reached or neared implementation, others have some room to go. In particular, uncertainty surrounding the Volcker Rule, risk retention, and the implementation of other Basel III banking rules remained a source of conversation throughout the conference.
The Asset-Backed Alert publication noted that issuance volume in worldwide structured finance deals rose from $515.9 billion in 2012 to $604.9 billion in 2013. Volume for U.S. asset-backed securities deals, however, fell short of expectations and declined from $220.4 billion in 2012 to $194.6 billion in 2013. In the commercial paper realm, the amount of asset-backed commercial paper outstanding, which is tracked by the Fed, fell from $303.7 billion to $268.3 billion (not seasonally adjusted).
Issuers were generally optimistic about their pipeline of new deals, as well as their ability to address the new rules. However, much of the new volume will likely continue to match run-off, as growth in both the long-term and short-term new issuance is expected to be subdued. New structure types and market entrants will likely stay on the sidelines until final regulations emerge on both the issuer and investor side of the trade.
The SFIG conference provided a great opportunity to share ideas. All involved in the industry are working hard to make sure that we have the proper platform going forward, and once regulatory and industry consensus have been reached, the market will look ready to grow again along with the economy.
A new type of floating-rate note enters the market
In our November 2013 commentary, we discussed the scheduled January 29, 2014, debut of the U.S. Treasury’s first-ever floating-rate notes (FRNs). As we explained then, the interest rate on these FRNs resets daily based on the yield of the most recent 3-month Treasury bill (T-bill) auction, plus or minus a spread determined at the FRN auction. With a two-year final maturity, FRNs are eligible to be purchased by triple_A rated money market funds (MMFs), enhancing their demand. The daily reset feature gives the FRNs a weighted average maturity (WAM) of one day, which keeps a MMF’s WAM relatively low, but the two-year final maturity quickly pushes a MMF’s weighted average final maturity higher.
The January 29 auction did, in fact, go swimmingly, with $15 billion of FRNs auctioned at a spread of +4.5 basis points (100 basis points equals 1.00%) over the index. The bid-to-cover ratio was 5.67. While this new and unique security has no history or similar security to compare with, we note that the 2-year Treasury note auctioned the day before had a bid-to-cover ratio of 3.30. It may take a number of quarters for market pricing to settle in for the FRNs, given the special factors surrounding a rare new Treasury security. Initially, scarcity will play a role because prospective buyers must compete to own a piece of what is currently just a $15 billion issue (by comparison, there are about $1.5 trillion in T-bills outstanding). As total FRN supply builds up over the next two years, the nascent secondary market will mature and the market will likely find its equilibrium level. Additional demand may also come later from buyers who do not want to be early owners, whether by choice or because of system or compliance issues.
Fed extends reverse repo testing
On the same momentous day the FRNs were auctioned, the Federal Open Market Committee concluded its monetary policy meeting and announced that, in addition to continuing to taper its asset purchases, it would extend its reverse repo program (RRP) testing for another year, until January 30, 2015; it also increased the maximum size per counterparty from $3 billion to $5 billion, with further increases likely. We’ve written about this program a number of times over the past few months because it likely will have a significant role in the money markets for as long as the Fed’s balance sheet has such enormous girth. When the program first appeared in September 2013, we noted a few of the program’s limitations, which prevented it from immediately assuming a larger market role:
- It was not full allotment. While that remains true, the per-counterparty limit has risen from an initial $1 billion to $5 billion, and it will likely continue to grow. Even $5 billion probably effectively serves as full allotment for a number of counterparties.
- It was limited in duration, with testing set to expire on January 29, 2014. This was a key limitation because it discouraged investors from giving up any of their share of the repo market with their counterparties, for fear they would not get it back when the Fed program ended. Now the doors to the Fed’s repo shop have been open for a full year and, with the success of the program to date, it seems likely it will eventually become permanent. This development makes investors more likely to commit excess balances to the Fed rather than placing them in the private (that is, non-Fed) repo market.
- It was limited as to the intraday time of the program. The Fed has experimented with this, moving the operation closing time further back, from 11:45 a.m. to 1:15 p.m. Eastern Time. Although this has helped capture more of the later investment flows, the limitation still exists and will not be fully resolved until the facility is open the entire trading day.
The chart below demonstrates how use of the Fed’s RRP facility has increased, especially as rates in the repo market have remained under pressure. When repo rates were clearly higher than the facility rate, usage generally only increased at each month-end, which is when the repo market temporarily contracted due to dealer window dressing. With repo rates grinding lower, usage has increased steadily, averaging $73 billion per day since December 20, compared with $8 billion per day over the preceding three months.
With the extension of the test period into next year, we expect to see additional counterparties using the program as well as increases from those who are already using it. So long as the RRP rate remains above the GCF Treasury repo rate, we would expect to see an increase in the total size of the program.
Federal reverse repo program and GCF repo rates
Sources: Bloomberg L.P., Federal Reserve
Past performance is no guarantee of future results.
Rates for sample investment instruments
Current month-end % (January 2014)
|Sector||1 day||1 week||1 month||2 month||3 month||6 month||12 month|
|U.S. Treasury repurchase agreements (repos)||0.03||0.03||0.04||–||0.05||–||–|
|U.S. Treasury bills||–||–||0.06||–||0.03||0.04||0.07|
|Agency discount notes||0.01||0.01||0.03||0.05||0.07||0.08||0.12|
|Asset-backed commercial paper—First Tier||0.12||0.13||0.16||0.18||0.21||–||–|
|Dealer commercial paper—First Tier||0.11||0.12||0.14||0.16||0.19||0.27||–|
Sources: Bloomberg L.P., Wells Capital Management
Past performance is no guarantee of future results.
A portion of the municipal money market fund’s income may be subject to federal, state, and/or local income taxes or the Alternative Minimum Tax (AMT). Any capital gains distributions may be taxable. For the government money market funds, the U.S. government guarantee applies to certain underlying securities and not to shares of the fund.
The views expressed and any forward-looking statements are as of 1-31-14 and are those of the fund managers and the Money Market team at Wells Capital Management, subadvisor to the Wells Fargo Advantage Money Market Funds, and Wells Fargo Funds Management, LLC. Discussions of individual securities, or the markets generally, or any Wells Fargo Advantage Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.