From the Lending Desks: Fixed Income

Treasuries

2009 brought record coupon offerings as the Treasury sold more than $2.1 trillion gross in bond and notes for the year, exceeding the prior two years combined. Moreover, net issuance in coupons grew from $188.50 billion in 2008 to $1.25 trillion in 2009. The old ten-year note, CUSIP 912828LJ7, became the largest issuance on record, with a cumulative outstanding of $63 billion after three offerings. Despite the record supply, investor demand for Treasury securities remained robust with strong indirect bidders, which include foreign central banks, and respectable bid to cover ratios at most auctions. November’s refunding of three-year10-year and 30-year issues was a record $ 81 billion, as compared to the previous refunding record in August of $75 billion.

The Treasury also announced an effort to change its debt portfolio characteristics, specifically aiming to lengthen the average maturity of debt from 4.4 years to 6.1 – 7.5 years. If successful, this would result in less reliance on Treasury bills and an increase of coupon issuance and Treasury Inflation-Protected Securities (TIPS). To this end, the Treasury reintroduced thirty-year TIPS, with the first auction to occur in February 2010. The Treasury is discontinuing 20-year TIPS auctions, effective immediately. Moreover, TIPS issuance for 2010 is projected to be $70 – $80 billion as compared to$58 billion in 2009. It is widely expected that TIPS issuance will continue to increase in coming years, at least in part to maintain the proportion of this asset class relative to nominal Treasuries.

The Fed Funds Open Rate averaged close to the middle of the 0.00% to 0.25 % stated target range for the majority of the fourth quarter, while spreads between asset classes continue to remain historically narrow at zero to two basis points. The number of issues trading special and at negative rebate rates has been relatively small. Additionally, ample liquidity for most issues combined with the added expense of a 3.00% fails penalty charge has drastically reduced the amount of Treasury fails in the repo markets. Limited balance sheet allocation amongst borrowers continues to negatively impact term markets, in the form of higher rebate rates, as borrowers continue to command a premium for these longer-dated trades versus open or overnight trades. We have, on occasion, engaged in a few short-dated term trades over month-end and quarter-end to maintain liquidity targets.

With both the economy and the financial system on the mend, market focus is now turning to the Federal Reserve’s exit strategy. As an example of this, the Federal Reserve has started to wind down and scale back some of their emergency lending programs. In the beginning of December, the Federal Reserve conducted several tests of its tri- party reverse repos while also implementing small scale reverse repos. While these tests have no immediate implication for monetary policy, they are a potentially important tool that the Federal Reserve will look to utilize when the economy and financial markets have improved enough for the Fed to drain excess reserves from the banking system. The Fed historically used short term repurchase and reverse repurchase agreements to temporarily affect the size of the Federal Reserve System’s portfolio and influence day-to-day trading in the fed funds market. Finally, near the end of December, the Fed announced a Term Deposit Facility (TDF) that would help drain excess liquidity from the system. Under this proposal, the Fed would offer term deposits that would pay interest on a bank’s excess reserves. Doing so would provide banks with another incentive to keep any excess reserves deposited at the Fed, rather than having these funds flow back into the economy and potentially stoke inflation.

In the final weeks of December, year-end pressure intensified as investors were looking for a safe place to invest cash from earlier gains made in riskier asset classes. Treasury bills, benefiting from this strong demand, had negative yields of one to three basis points for all maturities in early January. Repo markets also had an influx of additional cash, creating a concern that general collateral over year-end (December 31 to January 4) would also trade at a negative rebate rate. Ultimately, on December 31, the majority of early morning overnight general collateral traded at a zero rebate; however, later in the day general collateral traded at a negative rebate rate with some issues trading as low as a negative 3.00%.

Corporates

Corporate bond balances increased through the first half of the quarter and peaked in mid-November. Demand for general collateral was stronger than expected, and after balances dipped in late November, they increased in the first part of December. As year-end approached, activity tapered off and market participants focused on clearing up failing trades. CIT Group Inc., after working on an exchange offer in the month of October, filed for bankruptcy on November 1. Demand for CIT debt remained very strong through the month of October. By mid-December, the company emerged from bankruptcy and its new debt was in demand from borrowers.

At the end of October, the FDIC let its debt-guarantee program expire. FDIC-backed issuance by financial companies was one reason that 2009 was the busiest year for bond sales. By mid-December, $1.2 trillion of debt had been issued, a 46% increase from the same period of 2008. Credit spreads also rallied throughout 2009, with spreads on investment grade paper at the tightest spreads since January 2008, and spreads on high yield paper at the tightest spreads since December 2007. After reducing risk and protecting profits in late December, borrowers should be focused on taking on risk to start the new year.

European Fixed Income

Balance sheet de-leverage continued to limit demand for government bonds, especially over month and quarter-ends. Funding requirements and short coverage, rather than specials activity, drove demand, although the number of specials is increasing as we approach year-end due to illiquidity in specifics. Demand is becoming more concentrated within fewer borrowers. Reinvestment in high quality triparty collateral generally trades at lower levels than individual issues – so lending vs. cash is limited to those clients with wider cash reinvestment guidelines. Clients with very conservative guidelines see lending opportunities mainly when one country trades at a spread to another.

In its fight to rescue the still contracting economy, the Bank of England's Monetary Policy Committee voted to expand its bond-buying program at its November meeting.The rate-setters were split three ways with seven of the nine members voting for the lower than expected £25 billion extension, and possibly signalling that the program was drawing to a close. The asset purchase scheme (APS) first adopted in March will now see the Bank buy a total of £200 billion of UK gilts and other assets from financial institutions in the hope that the money spent will be invested in the wider economy. This increase (to be spent over the next three months) will mean that the Bank will be holding bonds worth more than 15% of Britain's entire economy in its balance sheet. There continues to be little in the way of any specials activity in the gilt market as the BoE continues to make purchased gilts (via the APS) available for on-lending to the market through the Debt Management Office’s (DMO’s) normal repo market activity. The Bank of England’s Monetary Policy Committee (MPC) agreed unanimously to keep interest rates at the record low level of 0.50%, where it has been since March, and said that cheap borrowing and quantitative easing were needed to prevent inflation falling below its 2% target.

The European Central Bank (ECB) allotted €96.94 billion at its third and last one-year LTRO (long term refinancing). The cost of borrowing will be indexed to the average minimum bid rate of the bank’s main refinancing operation, rather than fixed at one percent, as it was in the previous two tenders. The ECB’s decision to index the cost of the twelve-month funds will increase banks’ funding costs should the central bank decide to raise its benchmark rate from its current record low. €442.2 billion and €75.2 billion were allotted at the first two one-year tenders conducted respectively in June and September. There were only 224 bidders in December, a strong decrease from previous participation (1,121 bidders at the first one-year tender, 589 at the second). Demand was therefore more concentrated, meaning there are fewer banks looking for ECB’s liquidity - another sign of the improvement in the banking system. Liquidity provided to the eurosystem amounts to €750 billion, well above current needs (€575-580 billion). The market will therefore be long of liquidity until the end of June 2010, meaning that the overnight rate should stay in the 0.32-0.33% range for now. The ECB has flooded markets with cash to fight Europe’s worst recession since World War II and revive lending. Policy makers have said they will scale back emergency financing operations in 2010 and will encourage banks to pass on cash to the economy. ECB President Jean-Claude Trichet said December 10 that market conditions are “stable enough” to allow the withdrawal of some tools. “We’ll have a process of an orderly unwinding,” ECB Governing Council member Axel Weber said on December 9. He said the recovery of financial markets allows the central bank to “slowly and step-by-step” reduce the liquidity supply. As liquidity is withdrawn and rate hikes are eventually priced in, we will see more opportunity to generate spread from both specials and general collateral in the securities lending markets.

To view the next article, From the Lending Desk: Equities, please click here.