From the Lending Desks: Fixed Income

Treasuries and Agencies

At the beginning of April it appeared the financial crisis was in the rearview mirror as the global economy seemed poised for a sustained recovery and stability returned to the credit markets. By May, worries over the fiscal health of Greece set a negative tone to fixed income and equity markets. Greek sovereign debt concerns expanded to include other Euro zone sovereign debt as fears of contagion grew. In response, risk aversion returned, as investors seeking safe havens flocked to U.S. Treasuries and markets remained wary of the crisis in the Euro zone and subsequent country credit downgrades. Strong demand for Treasuries pushed up prices and dropped yields to year- to- date lows. The yield on the benchmark 10-year note fell to a low of 2.92% after peaking at over 4.00% in early April. Conversely, there was little evidence of a flight to quality in the repo market as rates remained stable and Treasury funding as compared to Fed. Funds were unchanged. Treasury general collateral traded close to opening Fed. Funds for the majority of the quarter. Trading activity continues to be driven by primary dealers’ emphasis on balance sheet allocation. That, combined with an ample supply of Treasuries continues to limit the number of issues trading at desk or special. All of the above factors combined led to a challenging quarter-end as borrowers began preparing for quarter-end in early June. Ultimately, Treasury general collateral traded as low as 0.0% the morning of quarter-end but traded as high as 0.65% later in the day as new Treasury supply pushed funding rates higher.

In the wake of the European crisis and the surrounding uncertainty, three month LIBOR has risen to levels not seen since July 2009, thus positively impacting the overall spread for lenders that include investments priced off of LIBOR. Term trade activity is mostly focused on specific issues with no right of substitution.

In a positive sign, deficit forecasts for this year’s U.S. federal budget have been scaled back as improved economic conditions have lead to higher tax receipts.  Also many banks and companies that received taxpayer bailouts were able to repay their debts early. The improved fiscal outlook means the Treasury can scale back from record size auctions which have begun with this quarter’s nominal coupon offerings for all issues,  excluding, the 30-year bond. This is good news for the government, the Treasury, and repo market, as record issuance has weighed heavily on the market to absorb new supply. May marked the one year anniversary of the Treasury fails charge, and similar to previous quarters the occurrence of Treasury fails has remained quite low. In addition to the fails charge, ample liquidity in most issues has also kept fails to a minimum. However, Mortgage Backed Securities (MBS) fails have increased and in response the Treasury Market Practices Group (TMPG) is exploring the possibility of expanding the fails charge to include Agencies and MBS securities. Although there have been an increase in fails of MBS this has had no impact on market liquidity. This is attributed to the “to be announced” MBS market as investors take on positions that have forward settlement dates and many of them roll these positions from month to month as a strategy  maximizing liquidity and minimizing fail concerns.

The Federal Reserve completed their purchase of $1.25 trillion in MBS in March 2010, however they continue to use dollar rolls as a supplemental tool to address temporary imbalances in market supply and demand that totals $9.2 billion in unsettled trades. In response on June 28 the Federal Reserve announced will begin conducting a limited amount MBS coupon swap operations in order to facilitate the timely settlement of the Federal Reserve’s MBS purchases. A coupon swap is a standard market transaction involving an agreement to purchase one agency MBS and a simultaneous agreement to sell a different agency MBS. The Fed plans to swap unsettled Fannie Mae 30-year 5.5 percent coupon securities (Fannie Mae 5.5%) for other agency MBS that are more readily available for settlement. Since the implementation of this program, dealers have had less MBS securities available for pledging as collateral which limits the demand for non-cash lending. The spread between Treasuries, Agencies and MBS remains narrow at 0-3 basis points.  On a term basis, Agency and MBS collateral continues to price at higher than overnight levels. Dealers continued emphasis on balance sheet allocation and capital charges presents challenges when trying to re-negotiate or to transact new term loans.

Corporate Bonds

The increased borrowing activity that characterized February and March continued as the second quarter began.  Balances grew in April as corporate bond spreads continued to rally.  In late April, for the first time in over a year, corporate bond spreads started to widen as concerns grew around the European debt crisis.  Balances dipped in early May, but, after the “flash crash” in the equity markets and the announcement in Europe of a plan to help Greece, started climbing again.  Balances peaked in early June, as spreads continued to widen, and remained range bound as market participants remained concerned about the Gulf oil leak, the possibility of double dip recessions in the United States and Europe, and ongoing concerns of sovereign debt in Europe.

After a torrid pace of new issuance by companies in the first four months of the year, the number of new deals, especially by non-investment grade companies fell dramatically in May and June.  In the first quarter, new investment grade bond deals totaled approximately $352.96 billion and new high yield bond deals totaled approximately $114.24 billion.  In April, approximately $52.67 billion of investment grade debt was issued and $33.39 billion of high yield debt was issued.

In May, companies found more difficult market conditions in which to issue new debt.  Investors demanded wider spreads and would not lend as much money, especially to non-investment grade companies.  May was the slowest month for U.S. corporate bond sales since October, 2008, with $25.62 billion of investment grade and $6.76 billion of non-investment grade debt issued.  Through the middle of June, $22.98 billion of investment grade debt had been issued and only $3.01 billion of high yield debt had been issued                                         

The monthly average of high yield companies coming to market has been 51.8 issuers, peaking in March at 82.  Through the middle of June, there have been only seven deals.  So long as companies continue to wait for more favorable conditions return to market, there will likely be an increase in secondary market trading.

After the Deepwater Horizon drilling rig explosion, we have seen increased interest in borrowing bonds issued by British Petroleum PLC, Transocean Ltd, and Anadarko Petroleum Corp.  Borrowing brokers have been actively borrowing corporate bonds from these issuers but have been reluctant to borrow bonds at negative rebates.  As June progressed, we did see more interest in securities at a slight negative rebate, but in most cases, borrowers continue to look for desk levels or a zero rebate.  As the story remains in the headlines, we should continue to see plenty of interest in bonds issued by these companies.

International

• EUR overnight rates likely to be more volatile after the ECB 1 year LTRO matured on 1st July.
• Securities lending spreads available in the European government bond markets were much higher during the quarter as uncertainty led to more specials.

After weeks of extreme volatility caused by market concerns that Greece could default on debt payments and lead to contagion into other weaker European economies, the 27 member states of the European Union and the IMF joined together to agree an emergency package worth €750 billion. This included access to €440 billion of loan guarantees for struggling nations and €60 billion of emergency European Commission funding with the remaining €250 billion coming from the IMF. During this period, shorts in “peripheral” European countries led to specific bond issues trading at very special levels in the repo market, while a flight to quality to “core” Europe led to most of the shorter dated German issues trading special. The increased demand for government bond collateral caused by European dividend season during April and May meant that this situation continued even after the rescue package was announced. Towards the end of June, with markets remaining relatively calm and dividend season drawing to a close we saw the number of fixed income specials start to reduce significantly. The ECB’s €442 billion 1 year repo matured on 1st July – with banks rolling their funding into 1 week and 3 month terms we expect short term interest rates to become more volatile in the months ahead.

The ECB and Bank of England left their benchmark rates unchanged at 1.00% and 0.50% respectively. After the emergency rescue package was announced, the ECB also began buying Euro-zone government debt “to ensure depth and liquidity in those market segments which are dysfunctional”.

The €55 billion of purchases (at June end) has had an impact on the front end of the peripherals with a number of sub-5 yr issues trading special as the available repo free float shrinks.

Some of the fees available for the most special issues during the quarter are highlighted below. With overnight tri-party repo trading on average at 0.20%, these specials all traded at negative rebates; until now a rarity in European government markets. Despite this, liquidity was not particularly problematic, with only a few short term fails in our program during the period:

By the end of May, the Greek repo market ground to a halt. Term repo between Greek domestic banks and other European banks rolled off and the free float diminished. After a period of the highest repo spreads in European bond markets since the advent of the Euro, volumes being traded fell dramatically as dealers cut back their positions and bond holders sold after prices rallied in the aftermath of the rescue package.

Gilt supply remained abundant with virtually all paper trading as general collateral across all maturities.

Activity in the credit market remained at elevated levels, although average spreads remained at 15bps due to the low rate environment and the reluctance of counterparties to borrow at negative rates. Specials are mainly limited to the high yield sector and are usually caused by illiquidity.

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