From the Lending Desks: Fixed Income

U.S. Fixed Income

First quarter 2009 began with the Federal Funds Target rate at historical lows of 0.0% - 0.25% and market uncertainty where Treasuries would trade in a near-zero-rate environment. Negative rebate rates were expected since Treasury general collateral typically trades below the Fed Funds Rate; however, massive Treasury issuance caused funding pressure and, for the majority of the quarter, Fed Funds traded at the high end of the new target range (.25%). Ultimately, Treasury general collateral traded 3 to 6 basis points above the opening Fed Funds Rate.

Treasury issuance this quarter was extremely large, accommodated by an expanded auction schedule and reinforcing need for additional primary dealers. The monthly seven-year note returned to the Treasury auction schedule after a 16-year absence. (Last quarter, the monthly three-year note returned.) To meet its ever-increasing financing requirements, the Treasury also increased issuance size and/or frequency of regular weekly, monthly and cash management bills, and coupon security offerings. Meanwhile, the number of primary dealers decreased again to sixteen, as the Merrill Lynch/Bank of America merger was completed. With the continued contraction in primary dealers over the past year and an expected $2 trillion of additional debt issuance this year, the Federal Reserve Bank of New York continued talks with at least four firms (including MF Global, Nomura Securities, Jefferies & Co. and RBC Capital Markets) to expand the list of primary dealers.

Demand from borrowers became cyclical, demonstrating stringent month-end balance sheet and compliance requirements, with net borrower demand continuing to decline. Toward month-end, borrowers unwound positions and returned securities, putting pressure on lenders to compete for borrowers’ remaining balance sheet. Balance sheet restrictions also dampened borrower appetite for term trades longer than one month, leaving premiums for longer trades unsupported by borrower demand. Newly formed commercial banks, such as Morgan Stanley and Goldman Sachs, were subject to additional regulatory restrictions, with the net effect that borrower demand for collateral remained limited.

The expected $2 trillion of Treasury borrowing in 2009 motivated dealers to price balance sheet exposure even more conservatively, with first quarter term bids exceeding the overnight collateral rebate rate by 15 to 18 basis points. J.P. Morgan kept term balances at a minimum, and engaged only in short-dated trades to focus on liquidity management over critical month-end periods.

Agencies and mortgage-backed securities maintained a 5 basis points spread to each other for the majority of the first quarter. Increased margin requirements for borrowers resulted in higher capital charges, and consequently higher term lending rates. In an attempt to reduce mortgage costs, the Federal Reserve Bank continued purchasing Fannie Mae, Freddie Mac and Federal Home Loan Bank debt, although the financing market remained unchanged.

Corporate bond balances fell for the first two months of the year with continued borrower deleveraging, before balances leveled off in March. As financial and auto companies remained in the headlines, borrowers showed little appetite for risk or for general collateral of any sector. Given the lack of demand, traders focused on cleaning up failing trades, particularly hard-to-borrow issues. Specials generally trade
with a zero rebate, although more issues had negative rebates, particularly in the gaming industry sector. Investment-grade corporate bond issuance increased, especially in the pharmaceutical sector with Roche Holdings Inc. and Pfizer Inc. issuing a combined $29.5 billion in bonds to fund acquisitions. Issuance of debt by financial companies through the FDIC’s Temporary Liquidity Guarantee Program (TGLP) remained robust. Issuance of high-yield debt picked up late in the quarter, as high-yield spreads rallied more than 200 basis points in the last two weeks of March.

International Fixed Income

First quarter 2009 brought extensive central bank activity, with the U.K. taking multiple actions to facilitate quantitative easing. The Bank of England cut interest rates by 150 basis points to 0.50%, created a permanent “discount window,” at which lenders can exchange on demand a wider range of collateral for T-Bills, and followed the Fed’s example of buying commercial paper from the non-financial sector. The Chancellor also granted permission to commence quantitative easing via the purchase of Gilts and corporate bonds up to a total of £150 billion. The European Central Bank reduced its benchmark rate down to 1.5% and, in a bid to revive the interbank market, announced measures to widen the corridor between the rate of the marginal lending facility and the overnight deposit facility to 200 basis points (from 100 basis points previously), effective January 21.

The lending markets generated strong demand for high-quality general collateral, with few opportunities to invest in specials. In emerging markets, lending opportunities remained limited to those clients with broader reinvestment guidelines, since most issues traded at or above the Fed Target range. Specifically, Russia and South Africa were the most actively traded markets. However, intrinsic value increased across the European corporate loan book with the majority of bonds trading upwards of 30 basis points (against an average over previous months of 15 basis points). European government bonds traded with little or negative value to overnight repo, but lending German, French or Dutch general collateral generated spread, particularly during the flight to quality following the news that Greece, Ireland, Portugal and Spain were having their credit ratings cut by one notch. Interest renewed for the term general collateral markets, with constant interest out to three months. The Gilt market also started the year with fewer specials than in 2008, as dealers pared down balance sheet usage. J.P. Morgan remained fully lent in most of the shorter maturities throughout the quarter, but returns gradually decreased versus noncash collateral. Clients who accept GBP cash collateral averaged 80 basis points throughout this period.