Despite the size and the depth of the US Treasury Repo market the primary dealers who make up the market on any given day need to cover short or long positions in US Treasuries in order to satisfy their client-based needs. This creates short-term arbitrage opportunities in the US Repo market by way of Treasury substitution. The dealers are willing to give up a basis point and in some cases more in order to meet their customer-specific demands. When leveraged this strategy can produce attractive returns in the low to mid double digits. It is a strategy that only trades when opportunities are present and all positions are covered simultaneously -- as is the case with all first-degree arbitrage. Up until now, this strategy has been primarily available to large dealers in the Repo market and a number of large hedge funds. The strategy itself is nothing new. What is new is our ability to provide access to this opportunity for smaller accounts. This strategy can achieve high returns on capital with very low risk because it’s an asset and liability-matched structure that’s market interest rates neutral. The structure is immune to rising or falling interest rates

The first stage of the strategy works by taking a repo loan using U.S. treasuries as collateral with matching terms. For example, a 6-month maturity U.S. Treasury would be financed with a 6-month maturity repo loan. Once the asset-backed repo loan is in place the second stage of the strategy is to make an unlimited number of collateral substitutions of the treasury asset which is allowable under the Master Repo Agreement. Substitutions are only made on higher-yielding assets and are done as frequently as possible. This type of arbitrage trade results in only positive gains as the substitution trade is only made with higher-yielding assets. If higher-yielding assets are not available at a given time, no substitution is made. 

One important trading rule of the strategy is that any substituted Treasury cannot have a maturity that is more than 16 days shorter or 16 days longer than the repo maturity. A collateral substitution is never executed unless the term is within 16 days of the repo and it has a higher yield. As the maturity of both the asset and liability will always have the same term within +/- 16 days, their modified durations will be about the same and

their market values will move about the same amount given a move up or down in their yields. Since the yields of the treasury and the repo loan move together, they are not subject to price spread. The maximum maturity is 12 months. The weighted average portfolio maturity of between 4 to 6 months. Only highly liquid U.S.treasuries under 12 months are used for collateral.

Collateral swaps are executed simultaneously with the same single counterparty to minimize counterparty risk. All treasury positions are offset every day and no bonds are held except for the term-matched repo portfolio held by the repo provider. Once settled the account accrues positive gains from any substitutions traded that day. All repo transactions are underwritten by the FICC, which is backed by the U.S. government, and also serves to minimize counterparty risk.

FAQs:

What credit risk are we assuming?

• The credit risk is the same as that associated with US Treasury securities. ie the US Government. Treasuries are generally assumed to be free of default risk.

Is the degree of leverage fixed?

• No, in an SMA format, leverage is dependent on the client's risk tolerances and return objectives. In an offshore Cayman version, the leverage is fixed.

Is the investment locked in?

• No, but generally speaking it is best to commit to an initial term of 12 months.

When is the best time to initiate?

• Yield volatility in short-term Treasuries is exactly what we want. We will strategically set up silos in key months where we think there will be higher activity. Activity and yield volatility in different maturity silos are driven by supply and demand ebbs and flows. Supply and demand imbalances are caused by the corporate bond dealer's new issuance calendar when institutional corporate bond buyers sell their short-term (1-to-12-month) 

Is the Treasury Repo Arb strategy in any way unusual or unique?

• No, it is essentially the same strategy that primary dealers employ in the repo space and several large hedge funds.

Is there counterparty risk with the repo provider?

• Not really. If the Repo provider failed to return (sell back) your Treasury, remember he may have your Treasury, but you took his cash. You didn’t invest any of your own money. You are playing with the repo providers' money.

Is there market risk?

• No. Because you sold your Treasuries to maturity. You’re not required to buy them back until maturity, at which time they will be cash. Cash has zero market risk.

What happens if the arbitrage profit opportunities go away? 

• They have existed for the past 40 years so it’s very doubtful they will go away. But in the worst-case scenario let’s say we trade for a few months, and it stops. And let’s say we only made a 3.0% yield enhancement. Where can you buy 6-month Treasury yields plus 300 basis points with near zero risk?

Many investors are now favoring low-risk yield-based strategies. It is expected that this strategy will be very popular with a wide base of institutional and high-net-worth investors

Initial Call:

Please get in touch with me using the link below to set up an initial call. Once we have done some primary KYC we can forward further details.

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Investment Vehicles

Separately Managed Account Min 5M USD

Offshore Cayman fund minimum 100K

(Accredited investors only)

MORE INFORMATION: 

If you would like to get more information about the Leveraged Term Repo Strategy, please feel free to call or email me. We can set up a Zoom call at your convenience.

Best Regards

James Rider

FxVolResearch





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