What happens if bonds have a bad, bad day?

by , 5th March 2018

Everybody knows that passive investing is the Despicable Me of investments and is gradually taking over the world. Something like 17.5% of all equity and bonds are now managed passively. I do not think that many know that passive investors are also taking over the world of securities lending. IHS Markit reports 65% of all loanable assets are from passive investors, up from 50% in 2008.

Furthermore, passive investors lending their securities are making a good bit more than their actively managed investors, something we should perhaps be slow to celebrate, because that comes by taking greater risk.

Lending other people’s securities is a big business for the passive industry. Its importance can be gauged by the revenues some of the big beasts made in 2016. Now, I know this is like comparing apples and kumquats, and it includes active lending, as well as other businesses, but BlackRock made $579m from its securities lending in 2016 and State Street made $562m from its Securities Finance business in 2016. I think it is safe to say that securities lending is the cherry on top of the management fee cake.

IHS Markit does not suggest why passive is becoming such a large part of the securities-lending industry, but I would suggest it may be due to the consolidation in the institutional asset management industry around a few mega fund managers. These funds and managers are strong advocates of passive investing and used stock lending as a tool to supplement fees.

What is less well known is that the average stock lending fee to passive investors is 5.1 basis points (bps) in the third quarter 2017, according to IHS Markit, a full 14% more than the 4.5bps earned by actively-managed funds made over the same period. That may not seem like much, but given low bond yields, it is not to be sniffed at. Historically, stock-lending revenues have been higher than at present, but what has been consistent is that passive managers generally earn more than active.

One of the reasons lending revenues have been dropping is the ‘chronic’ over-supply of loanable securities. Very broadly speaking, only 5% of equities and 30% of high grade bonds are out on loan at any one time.

The reason why passive managers are making more money in this area is fairly intuitive when you take into account the chronic oversupply of loanable securities. The answer is because passive lenders, in general, are willing to take more risk than their active peers by accepting lower quality collateral, or as IHS Markit say – because of the “willingness of passive funds to be pragmatic” or to be less picky towards the collateral they take.

This “pragmatism” is clearest in the area of high grade government bonds. IHS Markit reports that passive lenders of G7 bonds are able to double assets on loan and fees by accepting equities as collateral, generally viewed as lower quality, whereas ‘pickier’ active managers miss out by only taking high-grade bonds as collateral.

It is an open question why active managers are ‘picky’ and passive managers ‘pragmatic’. It may be a question of familiarity or it may be because passive managers have to generate extra income because of their low fees. Regardless, lending high-grade fixed income against equity does increase the potential risk of collateral shortfalls in the event of a Lehman-like event. Imagine what your boss or client might say if the super-safe TIPS, bunds and gilts ETFs are lost and you are left holding a portfolio of low quality submerging market ADRS and mid-cap equities.

In a meltdown your high-grade bonds could well shoot up, whereas your equity collateral will probably go into reverse, increasing the likelihood of a shortfall. Keeping an eye on what sits in your collateral basket therefore is important if you are concerned about counterparty risk. It is not sufficient to rely on loose and unwritten guarantees or undefined promises that only ‘high quality’ equity is taken as collateral.

I wonder whether the passive asset management industry has suffered from counterparty exhaustion over the last few years and this area is disregarded. Although it is nice to get the extra income into our fixed-income ETFs, it does come with some increased risk. If there is a market event at some time in the future we do not want to be the villain of the investment world. I would rather be the not-ugly-on-the-outside Gru, who does the right thing in the end.