Indexology^® Blog

In my blog “Introducing the CBLO Rate,” we discussed what the collateralized borrowing and lending obligations (CBLO) rate is and how the S&P BSE Liquid Rate Index would be useful for market participants.  In this post, let’s discuss the history of the CBLO rate and nature of CBLO rate movement.

The repo rate is the rate at which banks borrow from the Reserve Bank of India (RBI), and the reverse repo rate is the rate at which banks deposit their excess cash with the RBI; both are policy rates that move only when the RBI decides to change them during its periodic monetary policy review.  On the other hand, the CBLO rate is completely market driven and changes depending on the short-term liquidity situation in the market.

Generally, the CBLO rate should range between the repo and reverse repo rates, otherwise it would create an arbitrage opportunity for banks, which are active in both markets (repo and CBLO).  If the CBLO rate were to move out of the band of repo and reverse repo rates, banks could borrow from the cheaper market and lend in the more expensive market.  For example, if the CBLO rate is hovering around 5%, which is lower than the reverse repo rate of 6%, banks could  profit by borrowing at the CBLO rate and lending at the reverse repo rate (or depositing the same amount with the RBI), earning a risk-free profit of 1%.

Exhibit 1 illustrates the 30-day moving average CBLO rate, repo rate, and reverse repo rate.  The 30-day moving average is used to avoid outlier numbers and get a meaningful picture of all three rates.  From 2004 through the first half of 2009, it appears that the CBLO rate was more volatile and frequently outside of the repo rate and reverse repo rate band.  However, since 2010, the CBLO rate tended to be in between the repo rate and reverse repo rate, except during the second half of 2013 and first half of 2014.   Starting in November 2009, the RBI asked banks to set aside 5% of funds borrowed under the CBLO as a cash reserve ratio in order to stop discourage arbitrage opportunities between the two markets.

Exhibit 1: 30-Day Moving Average 

While the CBLO market is gaining popularity among various money market instruments, at present it is only accessible to institutions such as banks, financial institutions, corporates, etc., and it is yet to become available for smaller investors.  Another problem with the CBLO is that the treasury manager has to roll over deposits every day unless he finds a borrower or a lender for the desired maturity in the CBLO market.  It is worth reiterating that the majority of liquidity is in overnight tenor, which means other tenor rates may have a liquidity premium as well.

One possible solution for this could be an ETF based on the S&P BSE Liquid Rate Index, an index that seeks to track the weighted-average CBLO rate.  An ETF fund manager would roll over the deposits each day to earn the daily overnight CBLO rate.  This would also open the CBLO up to smaller investors as they buy ETFs to get exposure in the CBLO market.  This could effectively help increase liquidity in the CBLO market further.

While we have a liquid overnight CBLO market, it will be interesting to see how the term segment of the CBLO market evolves in the future.

On Aug. 4, 2016, the Bank of England cut its benchmark rate by 25 bps to a low of 0.25%.  This move, coupled with its announcement of a GBP 70 billion expansion of quantitative easing, with GBP 10 billion committed for the purchase of investment-grade corporate bonds, is furthering the positive performance of these asset classes.  Quantitative easing is an asset-buying program that is meant to keep rates low to stimulate the economy.

The S&P U.K. Gilt Bond Index had returned 16.93% YTD as of Aug. 10, 2016, while the S&P U.K. Investment Grade Corporate Bond Index came in at 17.32%.  Both of these asset classes continue to rally.  Since the vote for the Brexit on June 23, 2016, a rally based on flight to quality was largely expected for the U.K. gilt market, but the U.K. investment-grade corporate bond market has also has seen significant tightening of yields, despite concerns that a Brexit would negatively affect U.K. corporations.  Since the Brexit vote, the S&P U.K. Gilt Bond Index has tightened 75 bps and the S&P U.K. Investment Grade Corporate Bond Index has tightened 105 bps.

The question remains as to how much lower yields can go and how the Brexit will actually unfold.  Brexit impacts on the U.K. economy are starting to come in, with U.K. manufacturing output for Q2 2016 reversing its positive momentum and experiencing a sharp decline.

Bankers and corporate treasury managers may be facing the challenge of parking excess cash for a short period, maybe overnight, to earn some income or interest without compromising the security of the funds.  Similarly, there are many banks and corporates that need cash in the short term at the lowest possible rate.  While there are many possibilities (the call money market or repo market, commercial paper, etc.) each comes with certain advantages and disadvantages.  In India, various banks, financial institutions, and corporates are increasingly using the collateralized borrowing and lending obligation (CBLO) rate to lend or borrow money, for periods ranging from overnight up to one year (although the majority of trades are overnight).

What Is the CBLO Rate?

Unique to India, the CBLO rate facilitates the borrowing and lending of funds with G-sec as collateral.  It is also considered secure, as Clearing Corporation of India Ltd. (CCIL) is the central counterparty to all trades and guarantees settlement of CBLO trades.  Also, all trades are executed through electronic order book and are anonymous.  One of the distinguishing factors of CBLO is “tradability,” which means it allows the lender or borrower to reverse the position.  For example, in the case of a borrower, he can repay a loan before the expiry of the term.  It is no small wonder that CBLO has evolved as one of the most liquid money market instruments in India.

Currently, the collateralized market, CBLO, has become highly liquid and is dominating the short-term market in terms of volume of transactions.  Over the last eight years, the trading volume of CBLO segment has become higher than the combined trading volume of overnight call and market repo markets.  Exhibit 1 gives the historical trading volume of the short-term market in India.

Source: Reserve Bank of India (www.rbi.org.in).  Data in INR billions.  Data as of July 31, 2016. Volume data is from Jan. 1, 2008, to July 31, 2016.

As CBLO is gaining popularity among banks, financial institutions, and corporates, it is difficult to know the returns generated by lenders by daily rolling of deposits in the CBLO market due to the lack of a transparent and rules-based benchmark.  With the launch of S&P BSE Liquid Rate Index, which is designed to measure the returns from a daily rolling deposit at the weighted average CBLO rates, we try to bridge this gap.  The index is calculated using the weighted average CBLO rate for transactions maturing on the following business day and with a settlement type T+0.

From Dec. 31, 2015 to July 31, 2016, the weighted average CBLO rate ranged from a low of 5.16% to a high of 7.36%.  However, the S&P BSE Liquid Rate Index had an annualized average return of 6.67% during the same period.

As income seekers are forced to take additional risk to meet income needs in today’s near zero interest rate environment, preferreds may be considered over high yield bonds for the following five reasons:

1. Significantly higher credit quality
2. Comparable yields and lower volatility
3. Tax advantages on income
4. Call risk appears limited in near term for preferreds
5. Lower exposure to energy and oil drawdowns

Higher Credit Quality, Lower Volatility and Comparable Yields
Preferreds have significantly higher credit quality than high yield bonds, have exhibited lower volatility and can offer similar yields with potential tax advantages on income as some preferreds provide QDI.

Call Risk Appears Limited for Preferreds
Both preferreds and high yield bonds share call risk, though preferreds tend to have more callable issues. The analysis of the S&P U.S. Preferred Stock Index shows that if all preferreds at increased risk of being called are indeed called over the next three years, preferreds would lose approximately 17bps per year versus high yield. For yield-focused investors, the preferreds’ call risk appears insignificant.

Low Exposure to Energy – High Yield bonds continue to be heavily influenced by energy prices.
High yield has both direct and indirect exposure to energy and has been heavily influenced by oil’s extreme volatility. Preferreds have little to no exposure to energy and may help investors diversify their risk away from energy sensitive assets like high yield bonds.

Conclusion
Within the preferreds space, high quality, investment grade preferreds offer investors access to preferreds while providing unique exposure outside of banks or the UK as well as a defensive tilt to hedge against down markets. In summary, preferreds appear well positioned against high yield bonds for investors looking for a combination of higher yields and lower risks.

In the print edition of the Wall Street Journal this weekend, there were two unrelated stories side by side, one about a firm’s self-dealing with 401(k) and another about Medicare.  After reading them together it became clear that these seeming unrelated stories unintentionally show that while active funds can be bad for your retirement and health, passive investing can be good for your retirement and health.  Let me explain.

In “Self-Dealing With 401(k),” we find an unhappy plan participant pointing out that one of the active funds offered by the plan had abysmal performance.  For the five years up until June 30, 2016, it posted an annual return of 4.7% versus 12.1% for its benchmark, the S&P 500.  To add insult to injury, the story reports that the expense ratio of this poorly performing active fund (0.8%) is far higher than an institutional index fund that tracks the S&P 500 (0.02%).  In the suit filed by this plan participant, the complaint says “plan participants would have had USD 130 million more had they instead been in an index fund that roughly matched the market.” That’s a decent amount of money that could have helped out with those participants’ retirement.

The next story about Medicare (arguably a topic many retirees care about), Laura Saunders discusses how many high-income Americans will be subject to increases in premium charges and the key number for planning is the modified, adjusted, gross income (AGI), which usually means a person’s adjusted gross income.  The higher it is, the more some will pay for Medicare.  So her piece goes into detail about how to keep one’s AGI down using charitable contributions, Roth IRAs, timing the receipt of income, etc., but it’s under the managing capital gains and losses section where we find this key observation, “passive investments such as broad-based index funds tend to pay out less annually in capital gains” and it’s taxable capital gains that can raise an AGI.

Were these two pieces intentionally published side by side in the print edition?  Probably not because I don’t think the authors thought someone from the indexing industry would see that taken together, both stories created a real and tangible case study for those thinking about retirement and Medicare to embrace passive investing as way to better prepare themselves.  Lest this observation be taken as merely anecdotal evidence, I will conclude by pointing out “that within domestic equity, the majority of managers in nearly every category underperformed their respective benchmarks over the five-year horizon, for both retail funds and institutional accounts.”