Market Volatility and Rate Hikes Made for a Lively Spring and Summer
This semi-annual update discusses the current market dynamics that are impacting returns and risk in securities lending, State Street Global Advisors’ core views on securities lending programs, and some client perspectives on securities lending.
Market Dynamics
Since our last update in March, rather than entering the typical summer doldrums, equity market volatility has remained elevated. The volatility has driven securities lending returns up over 20% relative to the same period in 2021,1 and reminded investors that meme stocks are still alive and well, at least in terms of generating lending returns. Year over year demand increases were strongest in US Equities, European Equities, and Corporate Bonds. While lending demand remained robust through June and July, by the end of August the persistent upward trajectory of securities lending returns began to slow down. In the near future we will have more insight into whether this was due to summer vacation schedules of traders, the brief equity and fixed income market rally, or a more pernicious reversion in lending returns. That said, most securities lenders should be pleased with the past 5 months of strong returns.
While market volatility has helped revive securities lending returns, other factors have presented challenges. Notably, the Fed has kept securities lending markets on their toes with an aggressive rate tightening cycle not seen in years. The Fed’s message has been consistent, once the central bank backed off the characterization of inflation as “transitory,” which has frequently surprised markets expecting a pause or softer approach.
How does Fed activity and the level of interest rates impact lending markets? Securities lending is an exercise in asset-liability management that doesn’t focus as much on the notional value of interest rates, but rather on the spread between lending rebate rates and reinvestment rates. This spread can be heavily influenced by duration in the reinvestment fund, or more precisely, duration differences between the loans and reinvestment of cash collateral. For example, most securities loans are executed on an overnight basis. However, reinvestment funds often have some duration greater than one day as cash reinvestment managers purchase some assets with longer maturities. Due to these duration differences, management of this asset-liability mismatch becomes a heightened risk for securities lending programs in times of increased and unpredictable interest rate volatility.
How does duration in a reinvestment portfolio impact a securities lending program?
As with any cash investment portfolio, a longer duration portfolio tends to underperform on yield in an unexpected rising rate environment. However, in a securities lending cash collateral reinvestment fund, the challenges can be compounded. Not only does a low yield negatively impact returns in the lending program, but given the asset-liability nature of the activity, it can also inhibit the execution of new loans, or even the ability of the program to sustain existing loans at positive spreads.
SSGA’s Strategic Approach to Lending
SSGA focuses on intrinsic value in securities lending, and seeks to mitigate reinvestment risk to the extent possible. Firstly, SSGA’s acceptance of non-cash collateral eliminates reinvestment risk (including duration risk) entirely, and has been particularly useful in the current environment. Secondly, where securities are leant against cash, SSGA’s Cash Team has managed the cash collateral reinvestment portfolios to shorter durations in this rising rate environment. This limits exposure to aggressive surprises in Fed policy and enables the reinvestment rates to rapidly readjust after Fed rate increases. SSGA’s conservative approach to reinvestment exposure has served our programs well in the current rate environment.
Client Perspectives and Flows
SSGA has continued to see increased demand for our securities lending programs from clients confident in our risk-managed approach. While on the surface it can be hard to distinguish differences in securities lending programs, we invest the time with clients – explaining and providing the transparency needed to understand these differences. While we have experienced increasing returns from securities lending in 2022, our clients understand this is largely driven by increasing market returns and not by the assumption of incremental risk in the programs. We have heard particular appreciation for the quarterly factsheets on our securities lending programs that profile the risk and returns of the securities lending funds offered by SSGA. The factsheets not only provide a snapshot individually, but also, taken together over time, provide the clarity of trends in risk and returns of the lending program, and enable our clients to confirm that we continue to adhere to our risk and return objectives.