Spreads on US treasuries in securities lending are so thin that even the most stalwart securities lending participant has to wince. We see client evidence that in some months collateral returns account for 100% or more of total returns, meaning that clients are paying to lend their treasuries and relying on collateral to make up the difference. Is this wise for securities lenders and what happens in the next year?
Readers of this site know that the fundamental question here is risk vs. reward. Does lending treasuries for no spread and making a few bps off the collateral generate enough return to be worthwhile? Our answer is yes with a few caveats. We think that lending treasuries for cash may be the better option as it allows for more flexible collateral reinvestments, but non-cash works alright too. The caveat is volume. We think that lending through a big custodial bank like BNY Mellon or State Street, a place that can really handle volume in these markets, is the best way to go. While we don’t like how the metrics look on paper compared to other asset classes (utilization is way too high compared to Return on Assets Lent), we can’t argue that the strategy generates income. We also feel that the collateral exposure created by the loans is acceptable so long as the lender is paying good attention to what is in the collateral pool.
As with a variety of other asset classes, there will always be demand for US treasuries for hedging and operational purposes, if not directional shorting. The collateral upgrade trade is a great example, where borrowers simply need treasuries to fulfill other collateral obligations (so long as they last – see our most recent post on collateral upgrades here).
Looking to the next year we don’t see the situation getting any better. Low interest rates into 2014 give no incentive for spreads to rise in the US treasury market. Meanwhile, collateral management opportunities for all the low risk, highly sought after paper are still very low. We see no real change coming to this part of the market until US interest rates rise, hopefully within our professional lifetimes.
What do you think? Is lending US treasuries a good idea in today’s ultra-thin spread market, or is it better to hold off? Please leave your comments below.