General collateral rate

The repo market in linkers coexists alongside an old-style stocklending system. Issues seldom stray far from general collateral rates. Index-linked gilts are not strippable, and there is no index-linked futures contract. There is a sterling inflation derivatives market, which... 

TR swaps may also be used for speculation. Bond traders who believe that a particular bond not currently on their books is about to decline in price have a couple of ways to profit from this view. One method is to sell the bond short and cover their position through a repo. The cash flow to the traders from this transaction consists of the coupon on the bond that they owe as a result of the short sale and, if the shorted bond falls in price as expected, the capital gain from the short sale plus the repo rate—say, LIBOR plus a spread. The danger in this transaction is that if the shorted bond must be covered through a repo at the special rate instead of the higher general collateral rate—the one applicable to Treasury securities— the traders will be funding it at a loss. The yield on the bond must also be lower than the repo rate. 

This is part of the general collateral (GC) market, and is more common in the United States than elsewhere. Consider the case of a cash-rich institution investing in GC as an alternative to deposits or commercial paper. The better the quality of collateral, the lower the yield the institution can expect, while the mechanics of settlement may also affect the repo rate. The most secure procedure is to take physical possession of the collateral. However, if the dealer needs one or more substitutions during the term of the trade, the settlement costs involved may make the trade unworkable for one or both parties. Therefore, the dealer may offer to hold the securities in his own custody against the investor s cash. This is known as a hold-in-custody (HIC) repo. The advantage of this trade is that since securities do not physically move, no settlement charges are incurred. However, this carries some risk for the investor because they only have the dealer s word that their cash is indeed fully collateralised in the event of default. Thus this type of trade is sometime referred to as a Trust Me repo it is also referred to as a due-bill repo or a letter repo. 

In European RMBS transactions, bonds are not generally written down when losses are incurred in the collateral pool. Instead, the losses are recorded in a principal deficiency ledger, which records the extent to which the balance outstanding on the notes exceeds the remaining assets. Usually, both excess spread and the reserve fund can be used to cover losses and so pay down the principal deficiency ledger. This mechanism is beneficial to holders of the lower-rated notes because the notes do not get written off immediately and any future excess spread will be used to cover the loss. 

Exhibit 11.18 shows the principal payment rate is somewhat erratic on a monthly basis but has generally been increasing. However, with a collateral pool of 24 billion and principal collections running at their average rate of 4%, it would take less than one month to accumulate the principal required to redeem the largest outstanding note. 

Recovery rates for individual obligors differ by issuer and industry classification. Rating agencies publish data on the average prices of all defaulted bonds, and generally analysts will construct a database of recovery rates by industry and credit rating for use in modelling the expected recovery rates of assets in the collateral portfolio. 

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