Maximizing Portfolio Returns Through Securities Lending

Transcription

1 Maximizing Portfolio Returns Through Securities Lending Rich Blackman, Vice President, State Street Securities Finance Mary Ellen Mullen, CFA, Principal, Bridgebay Consulting, LLC

2 What is Securities Lending? Securities Lending is an investment management product whereby participants generate a fee for temporarily transferring idle securities, in a collateralized transaction, to a borrower COLLATERAL AND FEES LENDER BORROWER OWNERSHIP OF SECURITIES > In exchange for collateral and payment of fees securities are transferred from the lender to the borrower > Borrower agrees to return securities when the lender recalls 26

3 Market Participants Lenders Lending Agent Borrowers Corporate treasurers Pension funds Mutual funds Insurance funds Endowments Foundations Central banks Open Communication Custodians / Third party providers Open Communication Broker / Dealers Securities subsidiaries of U.S. and European banks Highly capitalized foreign banks Hedge funds 27

4 Securities Lending as an Industry > An effective investment strategy to earn revenue on existing assets > A global business with approximately $3 trillion on loan at any time > Low-risk investment strategy when properly managed > Securities lending provides liquidity to financial markets and has been embraced by the following regulatory bodies The Federal Reserve The G-30 Most foreign governments / central banks Securities and Exchange Commission (SEC) Financial Services Authority 28

5 Why Funds Lend > Participation typically meets fiduciary responsibility of maximizing shareholder value by adding incremental income in a risk controlled environment > Performance / yield enhancement Excess alpha > Managers obtain additional street-side views on shares held > Income without expenses Trading expenses typically absorbed by agent Dividends, interest, market value continues to accrue to the fund 29

6 Why do Funds Borrow? > Settlement failures > Short-selling Sector rotation, market neutral > Hedging Interest rate, index > Dividend, merger, convertible arbitrage > Financing Repo activities 30

7 What Drives Returns from Securities Lending? Portfolio composition Demand from borrowers constantly changing type / size Portfolio investment style Active or passive amount of turnover Trading know-how: Ability of the lender to secure optimal return Rate negotiation leverage Trade monitoring ability Collateral and borrower parameters Acceptable collateral Acceptable borrowers 31

8 Typical Corporate Treasury Investments Asset Treasury Bills Treasury Notes Strips / GC Treasuries 2 year 3 year 5 year Spread to Fed Funds Open basis points basis points basis points basis points 5 10 basis points U.S. Agency Municipals Investment Grade Corporate Benchmark Callable Pools GNMAs No demand Very issue specific 2 5 basis points 0 +2 basis points +4 bps / $20+ blocks +1 2 basis points 5 25 basis points 32

9 Loan Mechanics Custody Available Securities Securities Finance Collateral Investment Reinvestment 1. Securities data made available to SF via electronic links 2. Securities delivered; collateral delivered 3. Cash is reinvested; revenue equals the reinvestment rate earned less the rebate rate paid to the borrowers 4. Securities are monitored and marked to market on a daily basis. Diversified Borrower Base Note: Collateralization is 102% 33

10 A Typical Lending Transaction Client has $10,000,000 out on loan to a borrower for 10 days 60% Client Income $425 Lend securities 40% Agent Income $ % collateral ($10,200,000) Broker Rebate Rate: 5.10% Interest Due: $14,450 invest returns Money Market Fund Yield: 5.35% Earnings: $15,158 Rebate (negotiated interest rate) 34

11 Components of Return An Example Investment yield received 5.35% UST repo 5.25% Investment spread 10 bps Demand spread 15 bps Gross spread 25 bps Rebate rate paid 5.10% > INVESTMENT SPREAD Reflects market pricing and risk characteristics of reinvestment portfolio > DEMAND SPREAD (also known as INTRINSIC SPREAD) Reflects supply / demand characteristics of loaned securities; set by market Intrinsic value inherent in securities Special demand for particular securities is constantly changing 35

12 Securities Lending is an Investment Management Function with Similar Risks Counterparty Default Asset / Liability Management Cross Border Risk Operational Risk > Diligence in counterparty selection > Risk-adjusted exposure monitoring > Diversification > Collateral maintenance: 102% and 105% > Indemnification > Investment management expertise > Interest rate and liquidity management > Credit analysis expertise-independent issuer review > Legal / tax due diligence process > Documented disaster recovery procedures and policies > Compliance officers > Depth of resources > Reporting transparency 36

13 Items to Consider in Selecting a Securities Lending Partner > Look for partner who will optimize risk-adjusted performance, not just $ This is an investment activity and should be reviewed as such > Look to leverage your entire portfolio Maximize intrinsic value vs. volume of loans Reduce volatility of earnings > Manage program through diligence and transparency Risk management should be integral part of any program This should not be a black box activity these are your assets > Partner with you to meet goals 37

14 Our Securities Finance Division > Leading provider of securities finance services, including securities lending The largest securities lending agent in the world $2.6 trillion in lendable assets $500+ billion assets on-loan Providing securities lending for 32 years Experience in all market environments > Global Collateral Management is one of the largest short-term cash managers in the world over $500 billion > 300+ employees worldwide fully integrated business line Trading, market / credit risk management, tax, operations, client service, reinvestment > 450+ clients worldwide from 35+ countries, 60+ asset managers > Lending in over 30 markets 38

15 Reporting Capabilities Industry Leading, Next Generation Online Reporting and Risk Measurement Tools > SL PerformanceReporter accessible online. Sample reports include Daily loan activities report, daily earnings report, monthly earnings statement, monthly income attribution analysis, monthly market commentary > SL PerformanceAnalyzer risk-adjusted performance measurement tool is designed to quantify, manage and communicate the risk / return relationship in securities lending programs. It provides clients with a risk-adjusted context in which to effectively evaluate their securities lending program. > PerformanceExplorer securities lending performance measurement tool with the ability to evaluate lending returns against a broad universe of industry peers 39

16 Corporate Cash Considerations > SFAS-140 requires disclosure on the balance sheet of lending transactions cash only > Determine impact, if any, of gross up with tax, analysts > Options Maximize earnings opportunity by keeping loans outstanding across quarter ends Reduce cash loans to $0 and convert non-cash loans where possible Reduce all loans to $0 for quarter end 40

17 FASB-140 > FASB Statement No. 140 (Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities) provides accounting and reporting guidance for transfers of financial assets, including accounting for securities lending activities > FASB Statement No. 140 addresses Whether the transaction is a sale of the loaned securities for financial reporting purposes If the transaction is not a sale, how the lender should report the loaned securities Whether and how the lender should report the collateral How the lender should record income earned as a result of securities lending transactions 41

18 SFAS-140 > If the securities lending transaction includes an agreement that entitles and obligates the client to repurchase the transferred securities under which the company maintains effective control over those securities, then the client must account for those transactions as secured borrowings (not sales) and continue to report the securities on the statement of net assets. The client should record the cash collateral received as an asset along with the obligation to return the cash as a liability. > Generally, if the client receives securities (instead of cash) that may be sold or repledged, the client accounts for those securities in the same way as it would account for cash received. In this case the lender has no right to the collateral unless there is a default, so no accounting of the non-cash collateral is required. > Reporting Cash collateral received reported as an asset Obligation to return cash collateral reported as a liability MV of loans outstanding reclassified under cash and marketable securities Income typically recorded under other interest income 42

19 Sample Balance Sheet Asset 43

20 Sample Balance Sheet Liability 44

21 Sample Balance Sheet Disclosure 45

22 Sample Balance Sheet Disclosure 46

23 Best Practices for Securities Lending Mary Ellen Mullen, CFA Principal Bridgebay Consulting, LLC

24 Best Practices Investment Policy Third party custodian SAS 70 Pricing sources External manager contracts Affiliated brokers Conflicts of interest Counterparty risks Concentrations Exposure to other parts of company Evaluate primary and introducing brokers Insurance Clearing Review asset liability management Update portfolio risk controls Separate authorities and responsibilities Eligible investments Diversification by industry Credit quality scale back based on AAA Reduce issuer exposure to 2 5% Expand types of securities Establish approval criteria External manager (SEC Form ADV) Broker / dealer (NASD capital) Custodian (SAS 70) Investment consultant (SEC Form ADV) Set maximum loss constraints Establish process and authority for policy exceptions and credit downgrades 48 Copyright by Bridgebay Financial, Inc. All rights reserved.

25 Global Custody Performance Factors Internal Controls Internal Controls Safekeeping Safekeeping Securities Lending Securities Lending Client Client Service Service Investment Investment Managers Managers Settlements Settlements SAS 70 Annual Review Disaster Recovery Hot Sites Fidelity Bonds E & O Cash Administration Cash Administration Foreign Exchange Foreign Exchange Technology Technology On-line Services On-line Services Reports Reports Custody / Valuation Custody / Valuation Performance Performance Measurement Measurement Portfolio Compliance Portfolio Compliance Monitoring Monitoring 49 Copyright by Bridgebay Financial, Inc. All rights reserved.

26 Typical Reports Comprehensive on-line daily, monthly, and quarterly reporting including: Daily On-Loan Position Daily Borrower Exposure Funding and Collateral Spreads Daily Earnings Daily Collateral Holdings Monthly Detail and Summary Earnings Monthly / Quarterly Performance Reports Monthly Cash Collateral Performance Sheet Monthly perspectives newsletter on global lending markets 50 Copyright by Bridgebay Financial, Inc. All rights reserved.

27 Typical Custodian Reports Anticipated Cash Report Cash Forecast projects an account's cash flows from dividends, coupons, maturities, redemptions, principal paydowns, (return of capital), trade settlements and fees Holdings or Positions Report Displays the account's individual assets with security description, CUSIP, asset type, trade date, settlement date, amortized cost or book value, accrued interest, market value Tax Lot Information Position by lot level accounting, LIFO or FIFO, for tax purposes Income Report Taxable interest income, dividend income (DRD), tax-exempt income, state breakdown, AMT, income earned and accrued income (day count varies by instrument) 51 Copyright by Bridgebay Financial, Inc. All rights reserved.

28 Credit Ratings Moody s Standard & Poor s Senior Unsecured Rating Short-Term Equivalent Rating Senior Unsecured Rating Short-Term Equivalent Rating Aaa Aa1 Aa2 Aa3 P-1 MIG-1 AAA AA+ AA AA- A-1+ SP-1+ A1 A2 A3 A+ A A- A-1 SP-1 Baa1 Baa2 Baa3 P-2 MIG-2 P-3 MIG-3 BBB+ BBB BBB- A-2 SP-2 A-3 SP-3 Ba1 Ba2 Ba3 NP BB+ BB BB- B 52 Source: S&P, Moody s, Lehman Bros. Copyright by Bridgebay Financial, Inc. All rights reserved.

29 Securities Lending Programs Issues to Consider Years of lending experience Number of active lending clients Lendable base of assets Amount of assets on loan daily 24 hour trading capabilities globally or U.S. only Amount of non-custody lending volume Commitment to business, % of bank s total revenue from this business Custodian assets gained / lost Array of cash collateral investment programs available Reinvestment expertise internal or outsourced to third party Number of investment professionals, credit and structure expertise Assets under management in short-term assets 53 Copyright by Bridgebay Financial, Inc. All rights reserved.

30 Securities Lending Programs Risk Assessment How is Counterparty Risk evaluated Independent Credit Policy Group Credit Approval Process Frequency and ongoing review of borrowers Depth and breadth of credit analysis of borrowers Diversification of approved borrowers Collateral Management Short-term investment manager AUM Disciplined investment process Expertise and track record Acceptable forms of collateral Cash / LOCs / Securities Daily mark-to-market (margins) Conservative / High-Quality instruments Ratings by S&P / NAIC Class 1 Rating Number and Size of Liquidity Pools the more the better Commingled / separate account structures Your portfolio size as % of collateral pool 54 Copyright by Bridgebay Financial, Inc. All rights reserved.

31 Securities Lending Programs Risk Management Elements Borrower Default Indemnification Full indemnification against a borrower s failure to return securities Strength of the Agent Compliance Program Contractual / regulatory reviews Front-end trade compliance Continuous self-testing and monitoring Internal / external examinations Active liquidity management Asset / Liability critical to minimize liquidity risk Administrative oversight of investment vehicles 55 Copyright by Bridgebay Financial, Inc. All rights reserved.

32 Securities Lending Programs Risk Management Elements Proactive interaction with Client Product development Addition / approval of borrowers Operations Loan recalls Importance of integrated systems Reallocation of loans Recall from borrower Contractual settlement of sales discretionary Transparency On-line systems 56 Copyright by Bridgebay Financial, Inc. All rights reserved.