From the Lending Desks: Fixed Income

Global Fixed Income

With net gilt issuance already reaching £53 billion for first quarter 2009 and set to rise to £220 billion this fiscal year, the street continued to be very long paper and spreads remained thin. The Bank of England kept interest rates on hold at 0.5% for the entire quarter but announced that it will inject an extra £50 billion into the U.K. economy by increasing its asset purchase program to £125 billion. Permission has been granted by the Treasury to extend the program up to a total of £150 billion if considered necessary. Governor Mervyn King said it was "much too early" to assess the impact of its quantitative easing program but pledged to be ready for an exit strategy as soon as the economy starts growing again. Despite narrow spreads, shorter maturities traded with increased value for limited periods of time, particularly securities that were involved in buy-backs or deliverable into the futures basket. Gilt general collateral traded within a very narrow range around 0.50%, providing a relatively stable spread when lending verus GBP cash.

Multiple ECB actions in the second quarter supported quantitative easing. In April, the ECB lowered its benchmark rate by a quarter-point to 1.25%, less than the half-point reduction expected by most economists, and cut the deposit rate by 25 basis points to 0.25%. In May, the ECB cut its main rate by a further 25 basis points to 1% and also extended the maturity of the unlimited loans to banks to 12 months (from six months). The deposit facility rate remained at 0.25%. ECB President Jean-Claude Trichet said that the ECB had agreed on a €60 billion ($80 billion) plan to buy covered bonds - securities backed by mortgages and public-sector debt that have been hit hard by the crisis. Trichet did not rule out the inclusion of further assets later - thereby paving the way for full-fledged quantitative easing.

Volatile EONIA settings led to unstable Euro government repo levels, widening the range of second quarter trading spreads. From May 7 to June 4, EONIA traded in a range of 0.486 to 1.146 despite the ECB target rate remaining at 1%. During the period, banks became increasingly confident of their liquidity and deposited less cash with the ECB, driving EONIA higher. Spreads generated by lending both government and corporate bonds were therefore affected as the overnight general collateral rate moved, but term reinvestment level remained relatively stable.

U.S. Fixed Income

The quarterly May refunding totaled a record gross issuance of $71 billion, comprised of three-year, ten-year and thirty-year Treasury securities. The May refunding announcement introduced additional reopenings of the thirty-year bond, resulting in monthly thirty-year bond auction schedule that mirrors the monthly auction for ten-year notes. Monthly auctions of 2-year, 5-year and 7-year notes have also reached record highs with combined gross monthly issuance up to $104 billion for June.

Borrowers dedicated less of their balance sheet to Agencies and mortgage-backed assets (MBS), continuing to challenge lending activity. Many borrowers also continued to refrain from transacting term trades longer than one month in order to comply with self mandated restrictions on balance sheet usage. In an attempt to recover the cost of the margin premiums on Agency and MBS loans, which are calculated off of a spread to LIBOR rather than Fed Funds, borrowers increased their bid levels, resulting in higher rebates and lower spreads.

The spread between Treasuries, Agencies and Agency mortgages remained historically narrow, compressing fees for non-cash collateral securities lending programs and shrinking TSLF activities. The spread averaged zero to three basis points in second quarter 2009 and improving market conditions led to declining dealer participation in the Fed’s Term Securities Lending Facility (TSLF). As detailed in this issue’s Regulatory Corner, schedule 1 collateral (Treasury, Agency debt, and Agency-guaranteed mortgage backed securities) generated no borrower demand after April 2. With weak demand, the Federal Reserve announced on June 25 the suspension of TSLF auctions backed by schedule 1 securities, the suspension of the TSLF Options Program (TOP), and a reduced program for TSLF schedule 2 collateral (schedule 1 collateral and investment-grade corporate, municipal, mortgage-backed, and asset-backed securities).

The Treasury Market Practices Group (TMPG) recommended fails charge created select specials and negative rebate rates for many current issues. Although the intrinsic value of Treasury general collateral remained low, the implementation of the Treasury fails charge on May 1 prompted select few current issues to trade special. The fails charge (currently at 3.00%) has been the catalyst for two-year, five-year and ten-year notes to trade at negative rebate rates. Both the five-year and ten-year notes traded at negative rebates as low as -3.00% as short covering and delivery settlement concerns increased demand for both issues.

Negative overnight rebate levels on Treasury specials increased trading activity in term markets, as well. Even prior to the Federal Reserve implementing a stated target range of 0 to 25 basis points, Treasury issues that traded special in the overnight market were more actively bid in term. With an increased economic incentive due to the fails charge, many current issues were bid at negative rebate rates in term markets to their next auction date and beyond. Treasury general collateral continued to be priced expensively in term by dealers as balance sheet usage and margin premiums were priced into bids. Consistent with recent quarters, the lending desks’ Treasury strategy remained focused on overnight lending as a more effective way to capture the intrinsic value of Treasury securities.

The Federal Deposit Insurance Fund’s (FDIC’s) special assessment fee was lower than some expected, but its structure may have contributed to quarter-end window-dressing activity. As previously discussed, the second quarter special assessment fee was levied against all insured financial institutions, and was calculated by taking total assets less Tier 1 capital. The assessment created incentives for negative overnight interest rates in a variety of markets on June 30, as more money flowed into short money market instruments, including Treasury Bills and Agency discount notes. Ultimately, Fed Funds opened on June 30 at .24% and Treasury general collateral traded in a range of .03% - .06%.

The Federal Reserve continued its Permanent Open Market Operations program to purchase Fannie Mae and Freddie Mac Agency and MBS debt. The ongoing purchases have sharply reduced the supply of these securities in the marketplace, resulting in a reduced financing need by dealers and higher bid-side rebate levels on the lending desk. A challenging lending environment is expected to continue throughout the third quarter as the Fed fulfills its stated commitment of $200 billion in Agency and $1.25 trillion in MBS purchases. The Fed also committed to buyback up to $300 billion of Treasuries to help reduce benchmark yields, foster lower mortgage rates and bolster a declining housing market.

Corporate bond balances grew throughout much of the quarter, after bottoming out in mid-March, 2007. Despite high profile bankruptcies and corporate financial distress (e.g., General Motors Corp. and MGM Mirage, respectively), borrowers and their clients showed an increased appetite for risk as the quarter progressed. We continued to see steady demand for debt issued under the FDIC’s Temporary Liquidity Guarantee Program (TGLP) program. As financial institutions look to exit governmental funding programs, issuance of FDIC guaranteed paper has tapered off considerably.

Corporate defaults continued at a record pace through the second quarter. More than 140 corporate defaults occurred in the first and second quarters of 2009, well ahead of last year’s 34 defaults for the same period. The majority of defaults occurred in the U.S., with 103. At the same time, companies have sold a record $682 billion in debt through the end of the second quarter.