Muted Securities Lending Returns Aren’t Always Bad

This semi-annual update discusses key market dynamics impacting returns and risk in securities lending, State Street Global Advisors’ core views on securities lending programs, and current client perspectives on securities

Axel Hester
Director of Securities Lending 

Market Dynamics

The steady march higher by markets has provided little volatility, or impetuous for short demand, to drive stock borrowing. In addition, historically low reinvestment spreads on cash collateral, supported by the Federal Reserve (Fed) intervention, have driven securities lending returns lower. While securities lenders are always seeking increased demand for securities loans, we can be comfortable with low reinvestment yields when they reflect reduced reinvestment risk. However, disruptive market dynamics may be on the horizon. The possibility of the Fed tapering its asset purchase programs, as well as pending debt ceiling issues at the US Treasury, have the potential to roil markets and inject the volatility that the securities lending markets thrive on.

That said, securities lending is a long-term portfolio management tool – not an investment decision based on temporary market environments. Risk and return tend to flow together over time, and the current low-return environment is a reflection of the low risk profile of the lending and reinvestment markets.

From a longer-term perspective, securities lending markets are based on the economic principles of supply and demand. We continue to experience increased asset flows into lending programs, which have boosted the supply of securities to be loaned and depressed returns in the market. However, there is a glimmer of optimism on the demand side. In July, hedge funds’ short books generated the best alpha in over a decade as stock correlations fell to new lows. This is in stark contrast to the pain many hedge funds experienced during the meme/Reddit saga earlier in the year. Further, hedge funds are starting to see their first cash inflows after three years of steady cash outflows. As a significant component of short interest in the markets, a turnaround in hedge fund asset flows could translate into more demand to borrow securities in the future, supporting securities lending returns (or at least mitigating the effects of supply increases).

State Street Global Advisors’ Strategic Approach to Lending

Employing a strategic approach to securities lending, SSGA focuses on the demand-side value of securities lending (driven by borrower demand) while seeking to mitigate risks associated with the reinvestment of cash collateral. Our view is that the demand value for securities loans in the market is an alpha generator for portfolios, while the reinvestment side of the equation has a more marginal risk-return trade-off. Further, employment of aggressive reinvestment strategies to increase securities lending returns also tends to increase loan balances and exposure to heightened reinvestment risks. This has the potential to alter the risk profile of the portfolio strategy of a fund involved in securities lending. In recognition of this fact, SSGA emphasizes the use of non-cash collateral for securities loans (which avoids reinvestment risk entirely), and when cash is accepted, reinvests it conservatively. As such, we are comfortable with the current docile reinvestment market. While reinvestment returns may be low, so are the associated risks given high liquidity and Fed support. This may change with taper talk at the Fed, but that story is still to be written.

Client Perspectives and Flows

Demand for securities lending programs, as a means for incremental returns in portfolios, continued over the past six months, with our flows into lending funds outpacing our flows into non-lending funds. While market returns for securities lending are down, Investors continue to appreciate the risk-return trade-offs that securities lending programs provide to their investments.As clients re-engaged securities lending post-2008, risk continued to be front-of-mind. Current clients have been willing to reconsider lending programs, and were encouraged by program performance through pandemic-induced market disruptions in early 2020, but risk perspectives are still paramount. More precisely, we are frequently asked by clients to explain the risk-return trade-off and how it should be considered in the evaluation of lending programs. Comments on our strategic approach reflect SSGA’s perspectives; however, we appreciate that clients don’t simply accept these statements, but rather want to understand securities lending more deeply. We encourage our clients to reach out to their SSGA representatives for further discussions on this subject, as it provides us the opportunity to display one of the key tenets of our securities lending programs, transparency.