From the Lending Desks: Fixed Income

Highlights The Fed cut its target rate from 2.00% at the start of the quarter to a range of 0% to .25%. Borrowers continue to de-leverage and reassess their business models. Narrow spreads between Treasuries, Agencies and Agency Mortgages persist. The U.S. Treasury Department significantly changed its auction schedule. Corporate-bond new issuance was very light. We began accepting U.K. Eligible Bank Bills as a new collateral class on the Gilt book. In spite of decreased international balances due to borrowers de-leveraging, spreads across the entire book increased.

Shirley McCoy Global Head Fixed Income

U.S. Treasuries
The final quarter of 2008 brought numerous changes to the market as the pressures of a global recession and dysfunctional credit markets intensified. The Fed extended many of its earlier liquidity tools through April 2009, and, with the Treasury, introduced other tools such as the Troubled Assets Relief Program (TARP) and Term Asset-Backed Securities Loan Facility (TALF) to provide additional relief.

The FOMC also took an unprecedented step on December 16, 2008, when it cut the federal funds target rate from 1.00% to a range of 0% to .25%. As a result of all the liquidity tools the Fed has in place, massive amounts of cash have been pumped into the system, making it extremely difficult to maintain a specific target rate. Additionally, by setting a range of 0% to .25% the Fed has effectively removed any basis for an expectation of a future cut to 0%. Even before the FOMC’s cut on December 16, the Fed Funds open rate had consistently opened below the old target rate of 1.00%, with a low of .0625%.

Market dynamics are still in flux as borrowers de-leverage and carefully manage their balance sheet usage. These changes have reduced borrower demand and require paring down balances at every month-end. Rebate rates and Fed Funds are also at historic lows, creating a challenging lending environment. With ultra low rebate rates, there are very few issues that trade special, as Treasury general collateral trades in single digits. Additionally, narrow spreads between Treasuries, Agencies and Agency Mortgages persist.

The many liquidity facilities at the Fed’s disposal, as well as Fed Funds open rate’s being well below the target rate, continued to have a negative impact on the utilization of agency debentures (agencies) and mortgage-backed assets (MBS) as well. The spread between agencies and MBS held at 3 to 5 basis points for the majority of the fourth quarter. The capital charges many borrowers incur by transacting loans with a margin premium built into the price has significantly increased the lending rates and has also lead to many inconsistencies within the market. Many borrowers have been refraining from engaging in longer-term trades (a tenor of longer than 1 month) in order to comply with self-mandated restrictions on balance-sheet usage. We expect that current market conditions will continue to make trading a challenge throughout the first quarter 2009.

With borrowers focused on reducing leverage and balance sheet exposures, term rebate rates have become expensive relative to rates on overnight loans. At the same time, the trading desk has increased its focus on liquidity management while attempting to maintain balances and utilization during these challenging month-end and yearend reporting periods. We have, on occasion, engaged in short-dated term trades ranging from 1-week to 2-months, but only when absolutely necessary to navigate these stormy waters. Whereas Treasuries were once bid on from a vast number of borrowers at similar levels, term markets are now quite illiquid, with many borrowers bidding high above indicative market levels. At the same time, borrowers are generally not able to provide term bids longer than 3 months.

Increasing borrowing needs by the Treasury Department has necessitated changes to its auction schedule, as gross issuance will rise to a projected $1.5 trillion in fiscal 2009 from $724 billion last year. The retired 3-year note was resurrected as a monthly issue beginning in November 2008, and the 10-year note auctions will increase to monthly, starting in January 2009. As of 2009, the 30-year bond will be auctioned quarterly instead of the previous biannual new issues.

The amount of fails to receive and deliver increased significantly early in the fourth quarter, causing systemic fails. Contributing factors were the bankruptcy of Lehman Brothers Holding Inc., supply pulled from the street and ultra low rebate rates. Over time, fails did clear up as the Street aggressively paired-off trades, the Treasury Department reopened four issues that had large fails and primary dealers borrowed specific securities from the Fed’s System Open Market Account (SOMA) program. To provide greater incentive for primary dealers to borrow from SOMA, on December 16, 2008, the Fed lowered the minimum fee to borrow securities from 10 basis points to 1 basis point. The effect was immediate, as total borrows from SOMA doubled from 3.5 billion to 7 billion the very next day. To further address concerns with failed trades, the Treasury Market Practices Group (TMPG) announced proposals regarding fails. These proposals ranged from a penalty rate for a failed trade to mark to market procedures for trades that have been failing.

Corporate Bonds
In the aftermath of Lehman’s bankruptcy filing, AIG’s bailout by the federal government and Bank of America’s purchase of Merrill Lynch, demand for borrowing corporate bonds waned. Borrowers continued to de-leverage, reducing their risk and limiting their trading. Another major factor contributing to lower balances was general price deterioration of corporate bonds. With a lack of liquidity in the broader credit markets, credit spreads widened, reducing the price of the bonds and decreasing the value of the loans. Spread compression was a major factor as the quarter progressed, and by year end, with Fed funds trading consistently below 10 basis points, specials were trading at zero or a negative rebate.

Throughout the fourth quarter, new issuance for corporate bonds was very light. Activity picked up slightly in December, driven by banks and financial companies issuing bonds guaranteed by the FDIC. In early December, these bonds were widely located and several issues traded special. As shorts were covered, and with a robust pipeline, bonds were trading at GC levels by year-end.

In 2009, we expect activity to pick up as market participants return from the holidays. Increased activity from borrowers should lead to increased balances; however, we do not expect balances to reach levels seen earlier in 2008.

International Fixed Income
Owing to the continued deterioration of market conditions, a number of participants pulled out of the lending market thus restricting supply to the Street. The resulting liquidity impact drove spreads in all asset classes, particularly in the euro sovereign area where a good number of issues traded up to 100 basis points in Germany, France and Italy. With a range of issues trading special, demand to borrow GC versus non-cash collateral increased, which provided more lending opportunities for those clients with conservative reinvestment guidelines.

We began accepting U.K. Eligible Bank Bills as a new non-cash collateral class on the Gilt book. This new class has broadly similar characteristics to that of regular U.K. Bills with one week maturities, but is cheaper for borrowers to finance compared to regular gilt collateral. Being one of the first lenders to be able to take these in the form of a Delivery by Value (DBV) gave us a competitive advantage over our peers, and enabled us to increase our balances on the Gilt book.

Balances decreased due to borrowers deleveraging and positioning themselves around their balance-sheet requirements. Despite being in a falling-rate environment, average spreads on the book increased as, with no spread in lending GC versus overnight repo reinvest, utilization became predominantly limited to those lenders with relatively broad reinvest guidelines.