Just like Schrödinger’s cat, a fixed income security can be in two states at any one time.
Until tested in the market the bond can be considered both repo-able or lend-able.
The condition is decided upon by the observer, or to be more specific the bond holder.
When the bond is in a lend-able state the owner earns an interest for parting ways with the security for a given duration. When it’s repo-able, the owner pays out an interest rate for the same act. In both cases he receives cash collateral.
Of course, when the bond is in a repo-able state, that cash is seen as more valuable to the owner of the bond than the bond itself. When the bond is in a lend-able state, meanwhile, that cash is seen as less valuable to the owner of the bond than the bond itself.
Which state the bond finds itself depends entirely on the perspective and preferences of the market. Though when there is more demand for repo than borrowing, lending rates will have little bearing on repo rates. When there is more demand for lending than borrowing, however, that’s not necessarily the case.
With that in mind, the following factoid about developments in the fixed income lending market by way of Data Explorers is worth some attention (our emphasis):
The fixed income market has been in turmoil in the last few months. With ongoing sovereign wealth crises and downgrades, we look at how the securities lending market has reacted to recent developments. On the whole, we find that the total supply of bonds in lending programs has decreased 9% to around 5.1 trillion dollars in the three months leading up to the start of January (See Chart). Looking on the demand side, we find that there was a 7% fall in loans (See Chart), driving utilization higher. This has in turn helped fuel an increase in income generated by lending programs despite a fall in fees.
And with regards to European bonds specifically:
European bonds have seen the most in the way of turmoil over the last three months, with every sovereign bond, except for Finland, seeing a fall in the value of their assets held in lending programs. Amongst the sovereign bonds in lending programs to have witnessed the largest declines in value are Greek (-72%), Portuguese (-47.5%), Slovenian (-39.2%) and Italian (-35.4%).
On the demand side, there was a decrease in the value on loan of government assets of nearly 10% to USD 392 billion. Bucking the trend, Hungarian bonds witnessed the largest increase in loans which saw a 24.3% increase in loans to USD 1.3 billion.
From the inventory held by long only investors, the largest demand to borrow came from investors looking to borrow Slovakian bonds which saw 60.5% of the lendable supply out on loan (utilization).
There was strong demand to borrow French, German and UK bonds which recorded utilization levels of 42.1, 47.5 and 47.4% respectively; this demand is no doubt driven by investors looking to use bonds as collateral in repo and other finance transactions. Overall there was a 1.7% increase in the European sovereign bond utilization to 40.7%. The most expensive bonds to borrow were Greek, Portuguese and Slovenian bonds. Corporate bonds across Europe recorded a fall in the value of assets in lending programs of 18% to USD 424.8 billion, whilst demand to borrow fell across the asset class by 10% to USD 58.7 billion. This gave rise to a 1.1% increase in utilization to 12.6%.
In other words, the number of bonds available for loan (a.k.a loan inventory) is contracting, even in bond markets like Greece.
The contraction of the lending pools, meanwhile, is bleeding into rates charged, with Greek bonds becoming some of the most expensive to borrow in the market.
In the case of Greek bonds, it’s fair to assume that the lending pools have contracted because most of the inventory which was previously available is now clogged up at the ECB. What’s more, one can assume that a similar trend is affecting Portuguese and Italian bond markets too.
While it might seem counter-intuitive that market participants are paying over the odds for borrowing peripheral debt in a sovereign bond crisis, it does make sense if you consider that it’s the contraction of the lending pools (due to ECB intervention) which has, in a way, contaminated the bonds’ dual condition.
Because the experiment has been rigged to ensure the bonds will always escape alive no matter what, the bonds can now be assumed (in private markets, at least) to be almost certainly lend-able rather than repo-able. The bond’s death, in a sense, has been taken out of the equation.
In Schrödinger terms that means the cat has been immortalised.
A fact which possibly explains the recent mega specialness (lend-ability) of Italian bonds.
Related links:
Why Italy is ‘Oh, so special’ - FT Alphaville
Eurozone GC is splitsville - FT Alphaville