Flexibility to use credit collateral in the gilt repo market
As schemes continue to evolve their collateral resilience to market shocks and build out collateral waterfalls, BlackRock has been partnering with other market participants to develop new ways of enhancing collateral resilience.
During the gilt crisis in September/October 2022, BlackRock was able to leverage credit repo for LDI mandates where a segregated buy and maintain credit mandate was held alongside, relieving immediate collateral stresses. While this helped in the short term, the need to rely on accessing credit repo markets at a time of stress to deliver additional cash collateral creates potential risks.
As an alternative to this approach, BlackRock has been partnering with several counterparties to develop an alternative solution in the repo market – credit-collateralised gilt repo.
Credit collateralised gilt repo involves entering gilt repo to gain leveraged exposure to gilts within the LDI mandate as is typical in LDI strategies, but with upfront agreement that the repo can be collateralised with a broader, pre-agreed range of collateral assets. This allows credit being held in a buy and maintain mandate with BlackRock to be posted as collateral against the gilt repo in a scenario where gilt yields increase, naturally increasing the range of available collateral.
Different approaches to repo
Source: BlackRock. Illustrative only.
What are the potential benefits?
Both credit repo and credit-collateralised gilt repo add collateral resilience by expanding the collateral pool and allowing otherwise ineligible assets to contribute to the collateral buffer. Deploying credit-collateralised gilt repo may allow schemes to avoid the sale of credit assets in a scenario where yields and spreads have suddenly spiked. As we saw in September/October 2022, sudden market moves can cause dislocations in credit spreads. Having the ability to post credit as collateral baked into gilt repo can potentially avoid the disposal of credit assets at unattractive valuation levels – this may support market stability in credit markets and avoid forced selling or herding behaviour from pension schemes.
The key difference between using credit repo as and when you need it and running credit-collateralised gilt repo with credit on an ongoing basis is that in the latter case the ability to post the credit is already built in. This contingent nature means that if yields do increase, then for the life of your remaining gilt repo positions implemented with this optionality to post credit, additional collateral capacity will be available through the option to post credit. Using several staggered repo contracts allows for the management of roll risk and comfort that if a sudden shock occurs, the scheme can fall back on posting its credit without having to rely on accessing the credit repo market for new funding during a potentially volatile and uncertain period.
Credit spreads increased as gilt yields spiked and schemes were forced to sell credit
The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Source: BlackRock, Bloomberg. Data as at 05 June 2023. Credit spread uses iBoxx Sterling Non-gilt index. 30yr real yield is based on 2052 index-linked gilt.
This flexibility comes with some additional cost relative to gilt collateralised repo, however these costs are relatively modest when compared to the moves seen in credit spreads in 2022. We are continuing to source quotes from a wider range of our counterparty panel, but initial indications for credit collateralised gilt repo out to 6 month tenors indicate an uplift relative to straight gilt repo financing rates of 5bps p.a. or less. This compares to credit repo where the additional uplift over gilts can vary with the type of credit being posted, but is often 5-10bps p.a. above gilt repo for trades on an overnight basis (the market convention, more on which is included below). Term credit repo sees costs expand further, with 6-month credit repo costing up to 50bps above gilt repo prices.
Comparing credit-collateralised gilt repo to other approaches that have traditionally been used to convert credit into eligible collateral highlights that there are potential benefits around valuation transparency and operational setup that we believe are appealing.
Source: BlackRock.
Managing risks
All repo positions introduce both counterparty risk and roll over risk, but there are some subtle differences in the way these risks are managed across the different repo types.
Gilt repo contracts can be traded across a range of tenors and are by convention collateralised with gilts. This convention also holds for credit repo, potentially creating a further draw on gilt collateral after credit repo is put in place should yields or spreads increase. Credit-collateralised gilt repo turns this on its head. Another key difference for credit repo is that by convention it trades on an overnight basis, what is known as open, and automatically rolls over unless either party calls it back. This provides useful flexibility if you need the underlying corporate bond back quickly, for example if you had concerns about an impending credit event, but leaves a lot of potential roll risk.
Credit collateralised gilt repo allows credit to be posted as collateral both ways. While this is beneficial to the scheme in opening up a wider collateral pool, should yields fall the scheme needs to be comfortable that it would receive corporate bonds as collateral. Our counterparty credit risk team carefully reviews the counterparties we transact with and limit the corporate bonds we receive to a minimum A- rating, with haircuts of 20%+ included to provide additional protection in the event of a counterparty default.
Source: BlackRock. Data as of June 2023. Illustrative only. Repo haircut represents the difference in value between the bond and cash amount, while collateral haircut represents the amount of additional collateral that must be posted when meeting variation margin requirements.
What next?
BlackRock’s LDI and repo trading teams are continuing to work closely with counterparties to deliver this market innovation and ensure scalable operational support for ongoing collateralisation and valuation of positions. For schemes that are running buffers towards the lower end of the recent guidance from the Pension Regulator and Financial Policy Committee we believe this will become an attractive tool in the armoury for ensuring both collateral efficiency but also increasing resilience.
We are keen to partner with clients who are interested in helping develop this market by making it eligible within their Investment Management Agreements. If you would like to understand more about how this approach may benefit your scheme, your LDI Client Portfolio manager would be delighted to discuss this further.
