Reverse Repurchase Agreements
By lending their fixed income securities on a short term basis, security holders can enter into the opposite side of a repurchase agreement, which is formally referred to as reverse repurchase agreements. Reverse repos offer the holders of fixed income securities an opportunity to raise funding at attractive rates, to increase their portfolio return through arbitrage programs, and also to participate in leveraged market plays.
Holders of high quality fixed income securities can lend their securities through a reverse repo transaction and raise funds at significant discounts to traditional forms of borrowing, whether that is bankers acceptances, commercial paper or bank lines. The previous strategy could be especially useful to those entities looking to borrow funds and whose name and credit rating would not be well received in the commercial paper market or to foreign borrowers whose name is new to the domestic credit markets.
Reverse Repos can also be used to garner incremental portfolio returns by the use of arbitrage activity. Specifically, if a security can be lent out (through a reverse repo) at a discount to prevailing short term interest rates - the lender of securities can then take out the spread between the lending rate and the higher short term reinvestment rate. A variation of the previous strategy is a reverse to maturity. This arbitrage can be especially valuable to individuals holding securities whose market value is inferior to its original cost and where an outright sale would generate a capital loss. By entering into a reverse to maturity, the security holder lends out his securities for the balance of the maturity term on the security and then reinvests the proceeds at the higher prevailing short term yield. As a result of this reverse, the securities holder has in effect liquidated his "underwater" securities without incurring a capital loss and has at the same time improved the overall yield of his portfolio.
Finally owners of fixed income securities can enter into leveraged market plays by executing reverse repos. For example, an account could purchase a three month treasury bill and subsequently enter into a reverse repurchase agreement to finance the first 30 days of the T-bill term. As a result, the account has created a future 2 month asset which he believes will benefit from capital appreciation at the end of the reverse. In essence the securities holder is using the reverse repo to take advantage of his view regarding the future shape of the short term yield curve.
Advantages of reverse repurchase agreements:
- Increase profits and portfolio yield by reversing in idle securities.
- Decrease cost of funding, or access funding where otherwise not possible.
- Flexibility to meet individual needs, in terms of maturities and securities to reverse in.
- Vehicle for leveraged market plays.
Features of reverse repurchase agreements:
Open reverse repo: term contracts where the continuity of the transaction is contingent upon mutual agreement on the interest rate and term of the reverse repurchase agreement.
Term reverse repo: an agreement where the duration of the reverse spans a specified number of days, weeks, or months.