Many investors use “repos” as a tool to keep some funds liquid while earning more than a bank account. Repos pay investors interest over relatively short periods of time, for example, 30 days, 90 days and up to one year.

Despite its popularity, many investors don’t know the actual risk or mechanics of a repo. Today we try to outline what investors should know about their repos.

How does a repo actually work? The institution is effectively selling the investor a financial instrument with the promise to repurchase it for a specific price at a later date. The repurchase price is usually expressed in the form of an interest rate. For example, if you invest US$10,000 in a repo for one year, the institution may pay you three per cent per annum and thus it pays you US$300 upon maturity along with your original principal of US$10,000. Typically, these agreements have a duration of 30 days, 90 days, 180 days, or 365 days. The interest rates vary based on the tenor and the quality of the asset being sold to and repurchased from you.

What are the risks? It may be useful to think of a repo as a type of short-term loan to your investment house that is secured by an asset. What would you want to know if you were giving a loan to someone? Let’s take a look at what the bank does. When an individual walks into a bank for a loan, the bank wants to know that the borrower can afford to repay the loan when it becomes due. The bank will also require evidence of income and/or assets that can be liquidated to cover the repayment of the loan. The likelihood of the loan being repaid by the borrower, along with current market interest rates, will determine the interest rate applied to the loan. If the bank needs all that information to give you a loan — we should probably be more mindful when we are investing in a repo.

Just as it is with a bank loan, it is important for an investor to be confident that the borrowing institution can repay principal and interest at the prescribed date.

In order to have this confidence, it is imperative that the investor (ie the lender) knows what assets the borrower will be using to secure the repayment of the principal and interest. This will help in determining the required interest rate for the risk the investor is taking.

Repos secured by high-risk assets will have higher interest rates. Repos secured by lower-risk assets will have lower interest rates. The next time you hear of an extra attractive repo rate — ask about the underlying assets.

The quality of the securing assets is very important. Investors often enter into repurchase agreements without knowing which assets are securing the investment. They look only at the interest rate and agree to the investment if they consider the rate to be “high” when compared to current interest rates in the market.

However, the securing assets will determine the risk associated with the repo. As a primary rule, never forget that a high return is usually commensurate with high risk.

What kind of assets are used in repos? Financial institutions that offer repos will use financial assets as the security. The assets used may be government-issued or corporate-issued. These may include Treasury Bills, Certificates of Deposit, sovereign bonds, corporate bonds, corporate notes or even stocks. Knowing which of these is securing your investment will help to determine if the interest rate being offered is sufficient to compensate for the risk.

It will also allow for a more informed comparison between different repo offerings.

Despite the notion that a repo is virtually risk free, there is some risk associated with them. The risk of the repo is directly linked to the risk of the securing assets. There is also the risk of the institution not being able to repurchase the assets which it sold at the maturity date.

To assess this risk — you can ask for the “capital adequacy ratio” of your investment house — to check where they rank. The Financial Services Commission minimum is 10 per cent.

If an institution cannot repurchase the asset at maturity, the investor would be left holding the assets with the only option of looking to liquidate and try to recoup what was initially invested. If the market price on the assets are below the original purchase price, then the investor stands to make a loss.

Repos backed by government-issued assets are the least risky. Those secured by bonds and notes can be assessed by looking at the rating of the issuer by various rating agencies. Stocks would be considered the riskiest as they are prone to price volatility.

If you know the underlying securities for your repo, you are better able to compare the risk/reward trade-off that is being offered by different institutions. Ask yourself, “Is it worth taking on the risk for the interest rate being offered?”

Dwayne Neil, MBA, is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm Feedback: if you wish to have Sterling address your investment questions in upcoming articles, e-mail us at info@sterlingasset.net.jm.