From the Lending Desks: Fixed Income

It was widely expected the Federal Reserve would have started draining liquidity from the market during Q3; however, a slowing economy, a weak housing market and a stubbornly high unemployment rate have effectively put those plans on hold at this time. However, after the Federal Reserve’s August meeting the concern shifted from how to tighten to how to ease a little bit more. When needed, the Federal Reserve has the ability to conduct large scale reverse repurchase agreement transactions.

The Federal Reserve Bank of New York expanded its list of counterparties used for reverse repurchase agreements by adding 26 money market funds managed by 14 firms. These counterparties would be in addition to the existing set of Primary Dealer counterparties, with whom the Federal Reserve can already conduct reverse repurchase agreements.

The expected gradual shrinkage of the Federal Reserve’s balance sheet, a key component of their exit strategy shifted to keeping constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities (agency MBS) in longer term Treasury securities. The goal of the reinvestments is to keep constant the face value of domestic securities held in the Federal Reserve’s System Open Market Account (SOMA). SOMA holdings of domestic securities totaled approximately $2 trillion and this policy will ensure that these holdings remain near this level. Moreover, after the FOMC’s September meeting the Federal Reserve indicated a readiness to “provide additional accommodation if needed to support the economic recovery”. This statement to potentially ease further has been interpreted as the Federal Reserve’s willingness to resume large scale asset purchases specifically for Treasuries.

Overall funding rates remained stable as the Treasury general collateral traded close to the opening Fed Funds rate for the majority of the quarter. Trading activity continued to be driven by primary dealers emphasis on balance sheet allocation. That, combined with an ample supply of Treasuries continued to limit the number of issues trading special or at a negative rebate rates. Issues that have traded at a negative rebate rate are mostly limited to current issues for a short period of time. For example, the 10-year note traded at a negative rebate rate a week before it was reopened.  Although still not evident in the repo market, there has been strong demand for Treasuries in the outright market pushing yields to record or near record lows. Additionally, strong demand at the July auctions for 2-, 5- and 7-year notes set record low coupons of 0.375%, 1.25% and 1.875%, respectively for all three issues.

For quarter end, dealers started to prepare for new increased regulatory focus on the cyclical fluctuation in dealers’ balance sheets over financial reporting periods such as quarter end and year end. Recently, the Securities and Exchange Commission unanimously approved a proposal to reinstate a requirement that publicly traded companies disclose more information about their short term borrowings. The proposal, which is subject to 60 days of public comment before any final action by the commission, would require companies to report each quarter their average daily or monthly amount of outstanding short term debt, the maximum level of those borrowings and their weighted average interest rate. The details of a company’s liquidity and short term financings are to be included in the management discussion and analysis section of a company’s quarterly and annual reports. Because of this increased regulatory focus and dealers’ early preparation, quarter end saw higher financing rates with Treasury general collateral trading as high as 0.40% and MBS at 0.70%. A few issues also traded at a negative rebate rate including some bills and the 5-year note which traded at -.90%.

Agencies and MBS

In an effort to address the increase of Agency and Agency Mortgage Backed fails, the Treasury Market Practices Group (TMPG) is exploring the possibility of expanding the fails charge to include these asset classes. In the “Best Practices” document which was released in mid September, the TMPG skirted around the issue of expanding the fails charge, however it has not made the pending charge official. They have added strongly worded language to afford the market place an opportunity to remedy the situation on its own before it reverts to mandatory official policy changes. TMPG has made it clear that market participants should avoid practices that intentionally inhibit the efficient clearing of the market.                        

Financing rates for the Agency and Agency Mortgage Backed assets classes continued to price at a premium to Treasury collateral within a range of 0-3 basis points.  On a term basis, Agency and Mortgage collateral continues to price at higher than overnight levels. Dealers continued emphasis on balance sheet allocation and capital charges presents challenges when trying to renegotiate or to transact new term loans. Demand for term utilizing non-Treasury collateral remains strong as borrowers attempt to capture additional revenue; however the ability to achieve a positive reinvestment spread remains a challenge. The shorter maturity range, one month and less, is where we are able to maximize spread while minimizing risk for our clients.

Corporates

Corporate bond balances continued to grow throughout Q3. Despite expectations of a quiet summer, demand for general collateral was surprisingly strong. Corporate bond spreads rallied in July, helping push balances higher. The J.P. Morgan High Grade Bond Index rallied 18 basis points during July, from 181 basis points over comparable Treasuries to 163 basis points. The J.P. Morgan High Yield Index rallied 50 basis points during the month of July. During the rest of the quarter, spreads on corporate bonds remained range bound.

Activity picked up during August, and with a brief lull around Labor Day weekend, remained strong up to quarter end. The corporate bond new issue calendar picked up in August, and was even busier during September. With a few days left in September, Q3 has seen the heaviest new issuance of the year as corporations take advantage of the low rate environment. Through September 27, approximately $340 billion in U.S. corporate bonds were issued, of which almost $260 billion was investment grade and just over $71 billion was non-investment grade. Investor demand for bonds in the cash market met the new supply without adversely affecting spreads. Strong demand for corporate bonds kept brokers busy borrowing to cover trades in the cash market. By late September, balances had reached levels not seen since February 2008. The sectors in greatest demand were financials (e.g., Ally Financial formerly GMAC, and Istar Financial), followed by communications (Cricket Communication), energy (BP and Anadarko), and consumer goods and services including gaming (casino-MGM) and Retail (Rite Aid and Neiman Marcus) issuers.

International

Borrowing demand for European government bonds remained high throughout Q3 – although the number of specials decreased after the EU and IMF rescue package was announced. Shorts in “peripheral” European countries led to specific bond issues trading at higher spreads in the repo market, while a flight to quality to “core” Europe meant that the highest quality collateral was sought – leading to a lack of supply and Germany having the most specials overall. European peripherals often traded at a spread to Germany, creating lending opportunities which had been absent for the past few years. Government bonds across all European sovereigns regularly traded at negative rebates.

Shorter term bank funding, after the 1 year ECB LTRO rolled off in July, led to more volatile overnight rates in Europe. However, EONIA remained mainly in the 0.35% to 0.45% range right until the end of the period when more 1 year, 6 month and 3 month ECB long term funding rolled off. Overnight rates moved sharply higher as we moved into the new quarter and should end up trading much closer to the 1% target rate. The increased amount of peripheral paper being funded in the market rather than at the ECB will also lead to repo spreads between euro-zone countries trending wider.

UK Gilt supply remained abundant with virtually all paper trading as general collateral across all maturities. A few of the shorter dated issues had value from day to day, but spreads were significantly lower than in Euro governments.

Activity in the credit markets remained at elevated levels, leading to an increase in the average spread available for lending corporate bonds. The majority of corporate issues trading special continued to be high yield bonds with borrowing demand usually caused by illiquidity.

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