From the Lending Desks: Fixed Income

Treasuries

The new decade began with much speculation and anticipation as steadily improving financial conditions could allow the Federal Reserve to change its monetary policy and begin its “exit strategy.” As it was intended, the use of many of the Federal Reserve’s lending facilities declined sharply and ultimately the facilities were no longer utilized by financial institutions. The beginning of February officially ended emergency programs such as the Term Securities Lending Facility (TSLF) and Primary Dealer Credit Facility (PDCF), which have had zero utilization for months. Moreover, the Fed’s asset purchases of $1.25 trillion of agency MBS and about $175 billion of agency debt securities concluded at the end of March. A further sign of the continued thaw in the credit markets was the return to positive T-bill yields. After being at zero yields for much of December and January the yield of the 1 month bill increased to 9 basis points at the end of March.

In a testimony given by Chairman Bernanke to the Financial Services Committee, Bernanke outlined some of the tools the Fed would use to help drain liquidity from the market. These include reverse repos, interest on excess reserves (IOER) and a new plan being developed called the Term Deposit Facility (TDF), all of which allow the Fed to drain reserves from the banking system. After December’s successful testing of reverse repos, the Fed announced in March it will also expand its list of eligible counterparties. To date, the Fed has mainly dealt with primary dealers but will now include money market funds, given the large amount of reserves that needs to be removed. Additionally, the Fed said it will use Treasuries and debt sold by mortgage finance companies, Fannie Mae and Freddie Mac for reverse repos. The question that remains is the sequencing of steps and the combinations of tools the Fed uses as it shifts from its very accommodative policy. Although the Fed continues to stress no change to its monetary policy, the market was surprised both on February 18th by the increase of the discount rate to 0.75% from 0.50%, and also on February 23rd, when the Treasury Department, on behalf of the Federal Reserve, increased bill issuance from $5 billion to $200 billion for the Supplemental Financing Program (SFP). The SFP program proceeds are deposited in a special Treasury account at the Fed and were originally used by the Fed to support its liquidity programs. These moves by the Fed are still in their testing phase and do not signal the beginning of their formal exit strategy.

In a positive change from previous quarters, coupon offerings at Treasury auctions have peaked after setting records in 2009. Much of this new supply was quickly absorbed by the market, which initially caused an increase in general collateral rebate rates on settlement day. This cycle has repeated itself for many months as demand remains strong for Treasury collateral. However, the spread between Treasuries, Agencies and Mortgage Backed Securities remains narrow at 0-2 basis points, limiting the demand for non-cash lending and rendering the trade less viable due to lack of spread. Moreover, with the Fed’s purchase of $1.25 trillion in agency MBS, dealers have fewer agency MBS available for pledging as collateral. However, this change has had no impact on financing rates which continue to price at a premium to Treasury and Agency Debenture collateral. Term agency and mortgage collateral continues to price at higher than overnight levels. Dealers emphasize balance sheet allocation and capital charges, which present challenges when trying to re-negotiate or to transact new term loans. The ability to transact asset swap trades has returned to the market as corporate and asset backed repo product has become available, however in limited supply. This trading strategy has resulted in an increased yield of twelve to fifteen basis points across each of the lendable asset classes.

In the final weeks of March, Treasury general collateral traded at 6-7 bps for 3/31-4/1 in anticipation of a collateral shortage on the last day of the quarter. Typically, the end of the first quarter which is also Japanese year-end creates volatility in the repo market. This is attributed to reduced supply as some customers pull their Treasuries for quarter-end compliance combined with borrowers increased demand for Treasuries for quarter-end window dressing. After trading at 5 bps in the morning, general collateral quickly became scarce sending rebate rates as low as negative 25 bps later in the day. Also, the scarcity of many Bills pushed rebate rates as low as negative 125 bps as borrowers scrambled to cover positions.

The repo markets continue to experience a decline in volume, which is a reflection of the low target rate and the reduced leverage by the dealer community. Consequently, the J.P. Morgan program continues to focus on lending mostly on an intrinsic value basis.

European Fixed Income

Greece’s budget deficit continued to dominate much of the headlines throughout the quarter. Greek Prime Minister George Papandreou is attempting to secure an explicit pledge of European aid and cut his country’s borrowing costs as 20 billion Euros of debt comes due in the next two months. With Greek yields still at three percentage points more than Germany on its 10-year debt, Papandreou says Greece can’t afford to hold out much longer at current market rates. His appeal to the European Union to help him shift interest rates lower is being hampered by a deepening split among the bloc’s leaders. While French President Nicolas Sarkozy said the euro region would rescue Greece if necessary, German Chancellor Angela Merkel’s government has signalled that Germany is ready to force Greece to seek IMF assistance. Moody's said that Greece must execute perfectly its austerity plan or risk a ratings downgrade.

The ECB left its benchmark rate unchanged at 1.00%, as rising unemployment and concern around Greece hamper the central bank’s efforts to return the Euro Zone economy to health. Trichet’s comments that the solidarity of the euro area “is not necessarily well known” and that “its situation compares very flatteringly with a number of other industrialised countries” failed to convince the market. The end of March saw the ECB's final special 6 month tender. EUR 17.9bn was allotted which was far lower than the market expectation of EUR 70bn. It's seen as a positive sign that fewer banks now require central bank cash in order to fund themselves, although the market reaction to the tender results was quite muted with no real moves seen. The lacklustre demand for funds implies that the roll off of the 1yr tender in July shouldn't pose an issue as there is deemed to be enough liquidity in the banking system.

In the UK, the MPC kept the target for its asset-buying plan unchanged at £200 billion, and the benchmark interest rate was also held at the record low level of 0.50%.

Specials in the quarter were mainly concentrated in Germany, Spain, Italy and Greece. Of note were DBR 3.25 1/20 (DE0001135390) at 30 basis points ahead of a tap in January, BKO 1.25 12/11 (DE0001137289) at 25 basis points ahead of a tap, OBL 150 (DE0001141505) at 25 basis points ahead of a tap, SPGB 6 1/39 (ES0000011868) 25 basis points ahead of a tap and BTPS 3.75 8/21 (IT0004009673) at 20 basis points ahead of a tap.

Greek repo was a two-tier market as Greek domestic counterparts had to pay up to fund their positions. Decreased supply led to some illiquidity in repo and created the following Greek specials throughout the quarter: GGB 3.7 7/15 (GR0124026601) at 30 basis points; GGB 3.8 3/11 (GR0110019214) at 30 basis points; and GGB 5.9 10/22 (GR0133002155) at 30 basis points.

By the end of March, GGB 5.9 10/22 was trading at up to negative 3%, the most special we have seen any EUR government trade for some time, as a number of buy-ins hit the market. Gilt supply remained abundant with virtually all paper trading as GC across all maturities. Activity in the credit market slowly began to increase, although average spreads remained at sixteen basis points due to the low rate environment and the reluctance of counterparties to borrow at negative rates. Specials therefore remain very limited, principally focused in the high yield sector and are usually caused by illiquidity.

Corporates

Activity in the corporate bonds sector had a moderate beginning in the New Year. In keeping with two themes from the prior year, new issuance in early January remained consistent with 2009 activity and spreads continued to widen in the cash market. After the credit rally in 2009, participants were reluctant to take on greater risk as the market continued to surge. Brokers used this opportunity to review their borrowing needs and evaluate loans in order to lower financing costs. From a valuation standpoint, there were opportunities to sell short and dealers remained particularly focused on the debt sector of retailer, electronic component providers and hotel-casino operators.

In late January, spreads began to level off, partly due to concerns in the European Zone and partly due to belief in the sustainability of an economic recovery. Widening spreads resulted in a general increase in activity. General collateral balances began to increase in late January and continued into February. This growth trend remained consistent into the early part of March, when balances stabilized at levels last seen in October 2008.

As March progressed, the new issuance calendar increased activity after slowing during the month of February. Trading volumes in the cash market were also increasing concurrently. With a steady new issuance calendar and increasing volumes, and with much of the growth coming from the high yield market, we expect this trend to continue. Loans with a short tenor have been the trend and are expected to continue into the second quarter. Although many borrowers are not keeping trades open for very long, we do continue to see an increased volume of inquiries. Despite this churning activity, we expect balances to hold steady through the second quarter.

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