No such thing as a free lunch


Roger Reist of Zürcher Kantonalbank discusses the benefits of securities lending in the current low interest rate environment

At university we learnt that there was no such thing as a free lunch. The idea behind this popular sentence is that there is no risk-free return in finance. However, one investment vehicle can offer almost exactly that under certain circumstances: securities lending.

Zürcher Kantonalbank is rated AAA/Aaa by S&P, Fitch and Moody’s. As a consequence we always act as a principal for our securities lending clients, including private individuals and institutional clients. However, the excellent credit rating of Zürcher Kantonalbank is only one of two factors creating confidence. The other is the collateral, which our clients receive while we borrow their securities. On top of this, Zürcher Kantonalbank over-collateralises its securities lending clients. The collateral acts as a safety net in the very unlikely event of a default.

The Swiss National Bank (SNB) introduced a negative interest rate of 0.25 percent on sight deposit account balances on 18 December 2014. On 15 January 2015, the SNB reduced the interest rate to a negative 0.75 percent, hoping to stop the franc from appreciating any further. Subsequently, the whole Swiss franc interest rate curve dropped substantially. In July 2016, all Swiss government bond yields turned negative, including even those of bonds with maturities of up to 50 years. Investors and banks in general and pension funds in particular have been suffering from the very low interest rates. The law prohibits pension funds in Switzerland from investing more than 50 percent of their assets in equities. As a consequence, fixed income investments and real estate play a very important role. In order to avoid the negative rates fully, or at least partially, pension funds started to look for more lucrative investment opportunities. On one hand we saw an increased appetite for emerging markets bonds, while on the other hand, investments in equities, alternative investments and real estate were becoming more popular.

Looking at the first category: the risks of investing in emerging market bonds, include the usual risks accompanying all bonds, such as the variables of the issuer’s economic performance and the ability of the issuer to meet payment obligations. However, these risks are higher for emerging markets bonds due to the potential political and economic volatility of developing nations. Although emerging nations have made great progress in limiting country risks, they still are undeniably more prone to economic instability than developed countries.

Despite these risks, emerging market bonds offer numerous potential rewards. On top of higher yields, they provide portfolio diversity because their returns are not closely correlated to traditional asset classes. However, the yield spread of emerging market bonds versus US Treasuries has shrunk in the past months. One explanation for this development is the higher demand of investors for such bonds.

As mentioned above, securities lending offers an opportunity to enhance the yield of a portfolio in general. Especially in combination with emerging markets bonds, securities lending can generate a substantial incremental income while the risk is very low in a principal model with a highly rated counterparty like Zürcher Kantonalbank. In the securities lending market, demand for emerging markets bonds is currently very high, as are the fees paid. Demand is primarily driven by market makers, bid-ask spreads are wider than in bonds from developed countries, and activities are high. However, not all securities lenders are necessarily in a position to exploit the potential of a portfolio fully. The keywords are product variety, balance sheet capacity, network of potential borrowers, ability to offer term or evergreen transactions and collateral downgrade capacity.

Zürcher Kantonalbank can offer not only securities lending, but repo transactions as well. Its very strong capital base enables Zürcher Kantonalbank to allocate a sufficiently large part of its balance sheet to its repo desk. Furthermore, the bank has a global network of counterparties for securities lending and repo transactions. In addition, Zürcher Kantonalbank is a member of the major platforms like Eurex Repo, Eurex SecLend and EBS BrokerTec. Some securities lenders cannot offer repos and/or be members of the mentioned platforms, hence the overall lending volume of a portfolio will be lower. Another important factor is Zürcher Kantonalbank’s ability to lend high quality securities, such as government bonds from Germany, France, the US etc. on term or in so-called evergreen transactions. The beneficial owner of the borrowed securities retains their full flexibility and can sell the bonds at any time. Zürcher Kantonalbank bears the recall risk. Thanks to this ability, the bank can lend a maximum percentage of the total securities lending portfolio. Furthermore, it is fairly common that the quantitative and qualitative requirements of the collateral the beneficial owner receives from the principal are higher than those of the collateral the principal can demand from the big borrowers, for example, banks and broker/dealers. Certain principals do not have sufficient high-quality collateral to support this collateral transformation. As a consequence, they won’t be able to maximise the return of the securities lending portfolios. Zürcher Kantonalbank is in the fortunate position of offering its securities lending clients this collateral transformation.

Investors can improve their portfolio performance through securities lending. However, every investment bears some risk, and the most substantial one from a beneficial owner’s perspective is the counterparty risk. Zürcher Kantonalbank thus stands out as an excellent partner as it is officially one of the safest universal banks worldwide. With its excellent capital base, international network, advanced technology and the ability to offer a term and collateral transformation, Zürcher Kantonalbank can generate a substantial incremental yield for its securities lending clients. Especially in the current low-interest environment, securities lending can be an interesting tool to improve the overall portfolio return. Pension funds, at least in Switzerland, have increased their holdings in bonds from emerging markets in the past two years to avoid negative interest rates. Such securities are currently in very high demand in the securities lending market.

Participants interested in the incremental income offered by securities lending should be aware that there is no free lunch. All returns require that some risk is borne, and securities lending is no exception. However, if investors can find a counterparty with the highest possible ratings and receive high quality collateral, including conservative haircuts, there may not be a free main dish, but at least a decent free dessert.
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