From the Lending Desks: Fixed Income

Treasuries

Systemic delivery failures that once plagued the Treasury market have disappeared as market efficiencies return and market participants adjust to the new fails charge market practice. The third quarter was the first full quarter with the TMPG fails charge in effect. As expected, the intrinsic value of Treasury general collateral remained low and some current Treasury issues traded at negative rebate rates.

Narrow spreads between Treasuries, Agencies and Agency mortgages persisted, averaging 0 to 3 basis points. The narrow spreads were reflected in the low participation in the Fed's Term Securities Lending Facility (TSLF) by primary dealers. Auctions for schedule 1 and schedule 2 collateral were suspended in late June. Currently, there are no outstanding loans for schedule 2 collateral, and we believe this program will likely be suspended, as well. As market conditions continue to improve, liquidity programs are becoming relatively more expensive and potentially obsolete, creating an ideal exit strategy for the Fed.

Treasury issuance remained at elevated levels, as auction amounts for all coupons increased. The July month end and August quarterly refunding reached record levels of $109 billion and $75 billion gross issuance, respectively. During the quarter, the three-month LIBOR rate dropped from approximately .60% to .30%, leading to lower overall investment yields in the program. In other developments, the Federal Reserve Bank of N.Y. awarded primary dealerships to the following firms: Jefferies & Co., RBC Securities and Nomura Securities. This brings the number of primary dealers to 18. Additional applications are being considered and the Fed will award them in due time.

Although dealers' focus on balance sheet allocation and deleveraging has abated somewhat, term markets continue to price in a premium compared to the overnight rates. In addition, early in the quarter, fed funds futures started to price in a possible rate increase by early 2010, therefore adding to the premium for term trades.

Corporates

Corporate bond balances peaked in late July, at the highest levels since October 2008. Activity slowed in August, as traders closed out positions ahead of vacations. During September, balances began to increase and we expect balances to continue to slowly build. However, after recording sizable profits during the first half of the year, many borrowers are focused on protecting those gains, and could be cautious regarding how much risk they are willing to take on in the fourth quarter.

CIT Group Inc. attracted the most market attention. In early July, CIT was reportedly preparing a bankruptcy filing. The company remained in the headlines for the next several weeks and CIT debt was heavily located by borrowers. Some CIT CUSIPs traded between negative 5% and negative 10%. After the company successfully negotiated a bailout agreement with its lenders and completed a tender, lending supply increased and negative rebates rose. As quarter end approached, bonds remained in demand, although most CUSIPs traded in a range of negative 2% to negative 3%.

International

The Bank of England (BOE) left the key interest rate at 0.5% for the sixth consecutive month, but increased its Asset Purchase Facility by an additional £50 billion to a total of £175 billion. In spite of recent indications that the British economy is improving, the Bank maintained a cautious approach and, on several occasions, emphasized that there is no guarantee a recovery will be either strong or sustained. The £175 billion injection of cash into the UK economy is expected to be complete in the next two months, however further increases to the quantitative easing program have not been ruled out. As the free float decreased to less than 50% in many issues, particularly in the 5- to 15- year sector, these gilts began to trade more special in the repo market. This led to the Bank of England and the Debt Management Office (DMO) intervening to relieve any "undesirable frictions in the functioning of the market in specific gilts arising from the Bank's purchases". The Bank of England allowed the DMO to lend a significant amount of gilts purchased by the Asset Purchase Facility to the market through the DMO's normal repo market activity. As a result, overall repo spreads narrowed considerably and all but a few issues traded around general collateral levels.