Inflation and securities lending

Not being old enough to have the requisite wisdom, I suspect that inflation is being over played by many market commentators. That said, it is clearly the case that many companies are itching to raise prices and are using the New Year and the increase in sales tax in some countries as the moment to do this. The combination of rising input costs for many raw materials as well as the rising oil price means consumers are due to pay more if companies are to increase profits. What does this mean to securities lending? In a higher inflation environment, bond yields are less attractive and the income from lending government bonds is a sizable chunk of overall securities revenue (22% at present). It is worth checking the trends here.

 The 10 year UK Gilt that is most popular to own by those funds who lend pays between 3.75% and 5% depending upon which one you choose. The UK government borrowed a record amount – GBP 23bn – in November and will need to service this debt. Will they have to pay higher interest to secure a successful take up given investors may not be interested in assets yielding under 5% with no capital growth prospects?

The Daily Telegraph reports that banks are propping up the Gilt market, buying GBP10bn in November whereas overseas investors only bought GBP3.3bn which is a five month low according to the Bank of England. We can analyze the total Gilt inventory held by funds that lend and split this between those domiciled in the UK and those outside.

There is no need to panic since we cannot see a new aversion to Gilt holdings from international funds. Of the $260bn available to borrow in aggregate, $66bn is held by these funds. In fact, they have been increasing their UK government debt holdings through 2010 by 42% to a 3 year high but it did slow down in Q4. This increase was much more significant than for the less overdrawn Germany and by some margin.

Clearly, plenty of central banks, pension funds and insurance companies need to adhere to their investment guidelines. Most of these prescribe a certain allocation to government debt and these guidelines don’t change very rapidly. But change could be on the cards in today’s high volatility environment given that even the price of orange juice could be going up between 4% and 8% according to Dow Jones.

This is not just a government bond issue. We read that there is a huge amount of corporate bond debt maturing this year and in need of potential re-financing. This could lead to higher interest rate payments in the scramble for investor take up. Various European banks have already issued $ denominated debt this year including Deutsche Bank and Rabobank. With exchange rates the way they are with a slight investor aversion to the long term viability of the Euro, commentators expect to see more non US firms issue $ debt.

It may be that income from lending bonds could just come under the spotlight more this year. As we enter the year, 38% of the total daily securities lending revenue is from bond lending, yet returns from bond lending are two thirds lower now than the average return in 2008. Equities show less of a reduction from that period, with returns down about 50%, if we just look at the non dividend periods.  With commentators predicting another strong year for equities, it raises a question over the outlook for bond lending.