From the Lending Desks: Fixed Income

U.S. Fixed Income

In 2010, the Treasury Department sold an unprecedented $2.307 trillion of Treasury notes, bonds and TIPS, most of which was sold at historically low rates. It is projected that the 2011 amount of issuance will remain in excess of $2 trillion to help fund the budget deficit. From the beginning of this quarter, speculation surrounded the size and scope of the Federal Reserve’s return to quantitative easing, this came to be dubbed “QE2.” The first sign the Fed would resume asset purchases was in late August when Ben Bernanke spoke in Jackson Hole, Wyoming, stating a possible need to provide additional stimulus. Earlier in the year, expectations were for the Fed to begin their “exit strategy,” but as the economy remained weak and the Fed was falling short on both of its mandates of promoting stable inflation and maximizing employment, their need to provide further stimulus to the economy became necessary. At the conclusion of the November meeting, an announcement was made stating that the Fed would buy $600 billion of U.S. Treasuries over the next eight months to drive down interest rates and promote growth. On a monthly basis, the Fed will purchase an additional $75 billion in Treasuries on top of its ongoing $35 billion they have already committed to buying to replace mortgage-backed securities (MBS) that were maturing in their portfolio. In total, the Fed will potentially buy up $850 billion to $900 billion in Treasuries when the program ends in June 2011.

The effectiveness of this program in stimulating the economy and the effect this will have on Treasury yields is a subject of debate. Moreover, views also differ as to the impact this will ultimately have in the repo/securities lending market. By the end of June as $850 billion to $900 billion of Treasury supply is removed from the street, we expect Treasury GC rates to trade lower. Additionally, the spread between Treasury GC and Fed Funds will likely decrease with less Treasury supply and as Fed Funds revert to trading lower as a result of QE2.

Trading activity continued to be driven by primary dealers’ emphasis on balance sheet allocation. Because of the increased focus on balance sheets, the Desk engaged in various short-dated term trades to help maintain liquidity over the year-end turn. In contrast with past year-ends, there were fewer dealers with balance sheet room to borrow Treasury collateral over the turn. As a result, the Desk secured term commitments from dealers as early as possible. Ultimately, Treasury collateral averaged 0.27% and MBS averaged 0.40% on December 31. The majority of borrowers were not involved as reducing balance sheet usage remained paramount. The benefits of balance sheet neutral trades and the need to secure longer financing (as compared to overnight), has led to greater demand for non-cash trades. Although the spread between Treasuries, Agencies and MBS on an overnight basis remained low (0-2 bps), the spread widened (5-6 bps) as the tenure of the trade structure increased.

Currently, SEC rules require companies to disclose short-term borrowings by the end of the quarter. New SEC proposals, initially disclosed on September 17, would require financial companies to disclose the maximum daily amount of each specified category of short-term borrowings during the reporting period. Also required would be the average amount in each specified category of short-term borrowings for the reporting period and the weighted average interest rate on those borrowings. As proposed, “short-term borrowings” would include federal funds purchased and securities sold under agreements to repurchase (repo), commercial paper, borrowings from banks, borrowings from factors or other financial institutions, and any other short-term borrowings. The market expects the SEC to issue a final ruling by early 2011.

Though the newer SEC reporting requirements have yet to be finalized, dealers are moving quickly to comply. As a result, we expect reduced volatility over quarter-end and year-end reporting periods going forward.

Agencies and MBS

At the November meeting of the Treasury Market Practices Group (TMPG), a decision was reached concerning the failure to deliver charge and its relation to mortgage-backed securities (MBS). The findings concluded that, at this time, there will be no TMPG fail charge applied toward said securities. Currently, the TMPG has no further issues for the sub group to address, but the committee will reconvene in the future if the need to address other MBS market issues arises. Financing rates for agency and agency mortgage-backed asset classes continued to price at a premium to treasury collateral within a range of 0-3 bps for the majority of the fourth quarter. As we approached the final weeks of 2010, term levels were elevated to encompass the turn of the year, which traded in a range of 30-40 basis points for Agency collateral, and 80-70 basis points for mortgage-backed collateral. The shorter maturity range (30 days or less), is the duration where we are able to maximize spread while minimizing risk. Dealers’ emphasis on balance sheet allocation and capital charges continued to present challenges. In the coming weeks, we expect a great amount of attention focused on the Dodd-Frank Act, as the January 31, 2011 deadline passes to answer the study and develop recommendations regarding the options for ending conservatorship of FNMA and FHLMC.

Corporates

Corporate bond balances hovered near year-to-date highs through the first half of the fourth quarter. At the end of October, balances reached their highest level since early August 2007. From the middle of November through the end of the month, balances fell approximately 15%. Market participants were focused on cleaning up positions and reducing risk prior to the year-end push. We also saw significant recall activity due to transitions. This recall activity remained heavy into December, as clients sold positions to take profits prior to the end of the year. As December progressed, with the stabilized balances, activity tapered off with the approach of the holidays.

Demand for corporate bonds has been greatest in the financial sector. Approximately one third of our loans are in this sector. The most frequent issuers in the corporate bond space are financial companies, and borrowers are most often borrowing to cover trades in the cash market. Next year we expect to see good demand to borrow corporate bonds, especially in the high yield space. 2010 saw a record high yield issuance of approximately $289 billion. J.P. Morgan analysts forecast reduced issuance in 2011 of $235 billion. While lower than 2010, this would still be the second highest on record.

International

Balances and volumes in the international fixed income lending book reached levels not seen since the summer of 2007 before reaching all time highs towards the end of the quarter. The composition of the book is very different to what we had “pre-crisis” with notable trends being less term trades, intrinsic value in different asset classes and more spread between European sovereign issuers.

Borrowing demand for European government bonds remained high throughout the fourth quarter — shorts in peripheral European countries meant that specific issues continued to trade 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 demand in Germany, France and the Netherlands. Government bonds across all European sovereigns often traded at negative rebates.

While Irish Sovereign debt was fully funded until the middle of next year, the Government was forced to seek external aid to help bail out the country's banks. Early on in the crisis, the government had provided a blanket guarantee to the Irish banks, some of whom were now finding it impossible to borrow money in the markets and had experienced large outflows of deposits. Ireland will receive €85 billion in a seven-year aid package at 5.8% interest rate.

Europe’s peripheral nations, already struggling to find buyers for their bonds, will face more competition in 2011 as the region begins issuing new securities to fund the Irish rescue package. The European Financial Stabilization Mechanism (EFSM) and European Financial Stability Facility (EFSF) will raise €34.1 billion for Ireland in 2011, the European Commission said on December 21. Peripheral nations also will vie for funds against AAA-rated Germany and France, which plan to sell a combined €486 billion of debt next year. Spain’s funding needs are €90 billion and Portugal may require €19 billion, analysts estimate.

At their December summit, EU leaders failed to agree on topping up the temporary €750 billion emergency fund of which the EFSM and the EFSF form the main pillar. Portuguese bonds fell during the month after Moody’s said it might cut the country’s credit rating “by a notch or two,” partly citing the “likely deterioration in debt affordability over the medium term.” The ratings company had already put Spain’s Aa1 on review for a possible downgrade. While EU leaders agreed to amend the bloc’s treaties to create a permanent debt-crisis mechanism in 2013, they still need to iron out details of the plan and bridge divisions over immediate steps to stabilize bond markets.

EONIA traded in a much wider range (between 0.37% and 0.86%) this quarter despite the ECB target rate remaining at 1%. Shorter term bank funding from the ECB continues to mean more volatile overnight rates in Europe. Repo spreads between euro-zone sovereigns remained relatively narrow in the shorter dates but peripherals vs. core trended wider in term dates.

U.K. Gilt supply remained abundant with virtually all issues trading as GC across all maturities. The Bank of England left interest rates at a record low of 0.5% and held its bond purchase plan at £200 billion. Chancellor of the Exchequer George Osborne detailed the deepest budget cuts ever in Britain, eliminating 490,000 public sector jobs over four years and imposing a levy on banks to extract the “maximum sustainable” revenue, as the government looks to keep interest rates low and secure the U.K.’s AAA credit rating.

Activity in the credit markets remained high and intrinsic value remained strong but the average spread was affected week-to-week by the volatile overnight cash rates. The majority of corporate issues trading significantly special were high yield bonds with borrowing demand usually caused by illiquidity.

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