Had a very interesting call with a correspondent this morning about the European Repo Market.

Most writing on bond markets treats bonds as if they are a savings vehicle and that the pricing is determined by how risky savers think the loan the bond represents is.

I have struggled over the past 4 years or so to determine whether this model of the world was only partially wrong or completely wrong. The reason is that the marginal bond does not serve primarily as an investment vehicle but as collateral for repurchase agreements or Repos.

What really matters is not the probability of default but the time path of the probability of default and the correlation of the probability of default to other instruments. If I have a bond A whose default probability is concentrated in the out years and is inversely correlated to the default probability of other assets then A is quite valuable as a liquidity hedge because when *stuff* hits the fan I know I will still be able to Repo my bond for short term cash, which can have very high value.

If I have a bond B that has a more uniform default probability and that probability is correlated with other bonds, then bond A can be more valuable than bond B even if the hold-to-maturity value of bond B is greater under all possible states of nature.

This is because in a crisis bond A can be repo-ed for short term cash with very little haircut, while bond B will have to be sold. Thus at the very point in time where money is expensive, bond A gets me money more cheaply than bond B. This is potentially more important than the hold-to-maturity value of the bond – under all state of nature.

I emphasize the later point because I am not merely suggesting that Bond A pays off in a world where my marginal utility of income is higher. I am suggesting that because Bond A is unlikely to default during the crisis event – even if it will in this world line – means that it retains its collateral status during the crisis and therefore allows me to extract cash when cash is expensive.

All of this is to say that the Repo market is key to understanding the bond market.

Here is the problem though – Bond A’s are floating out there in the world trading at extremely high yields. They are Sovereign Debt from Eurozone members.

This lead me to believe that something is wrong with the European Repo market. I called a student of this issue, who can identify herself if she wishes, on this only to find out that not only was she confused but so seemingly is everyone else. This includes the Eurosystem expert – apparently there is only one – on the state of the entire Eurosystem Repo market.

So no one knows exactly what’s going on here.

Some odd key facts though:

  • German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate. I tell my students that this can’t happen. But, it is happening.
  • Auctions for Sovereign debt are not only over-subscribed but more over-subscribed as the yields rise. Implying that the appetite for debt increases as the yield does. This makes sense if you are planning to Repo the bond. What doesn’t make sense is why this doesn’t drive down the actual yield
  • Generally speaking there is enormous divergence in at the short end of Sovereign Debt curve and its not clear what theory of the world supports this.