Updates From the Fixed Income Desk

Treasury

The trend of higher funding rates continued into the first quarter of 2012. Treasury general collateral averaged 0.17%, which was 0.06% higher than the Federal Funds Open level. The last period in which Treasuries averaged below Fed Funds Open was during the third quarter of 2011. Part of the reason for the higher funding levels that we’ve seen recently can be attributed to the Federal Reserve’s Operation Twist which has led to dealers being net long Treasury collateral. Another cause of the higher rates this quarter is due to the seasonal build up in Treasury bills that occurs each year leading into the U.S. April tax date. Looking ahead to the second quarter, this trend will reverse and as a result, we expect weekly decreases in Treasury bill supply and lower general collateral rates.

With improved market conditions and outlook, the spread between Treasuries and other asset classes has narrowed. This has been reflected in non-cash trades as higher spreads experienced in 2011 have been reduced to as little as five basis points.

The market is now eagerly watching the U.S. economy for any signs that would indicate the need for additional quantitative easing once the Operation Twist program is completed at the end of June. Any future asset purchases would likely be concentrated in Mortgage Backed Securities. Given the improving U.S. economy and improving employment numbers as of late, we may not have a final decision by the Federal Reserve on “QE3” until late in the second quarter.

Agency collateral continued to trade one to three basis points above treasury collateral while mortgage backed collateral continued to trade two to four basis points above treasury collateral for the first quarter of 2012. Balance sheet considerations continue to be a large concern for dealers which challenges month-end and quarter-end positioning. This makes the partnership with our reinvest desk more important than ever. This trend is expected to continue into the second quarter. The Treasury Markets Practices Group (TMPG) fails charge for agency and agency mortgage backed securities took effect February 2012. Securities subject to this charge include agencies issued by Fannie Mae, Freddie Mac and Federal Home Loan and mortgage backed securities issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. The calculations are similar to those charges for fails on treasury securities however mortgage backed securities will be granted a two day grace period which will be known as the resolution period. To date this charge has had limited effect in the market, with just a few agency issues trading special and slightly negative for a very limited period of time.

Corporate

Contrary to the past several years, balances in the corporate bond space did not strongly rally to start 2012. Where an increase was expected, daily average trading volumes in the high grade market remained at the average of $13.3 billion per day while in the high yield market; the average daily volume fell to $4.9 billion, below the $5.6 billion average of the past three years. Activity and balances accelerated in February. New issuance, which also had a slow start in January, picked up dramatically in February. Globally, more than $365 billion of corporate bonds were issued, up from $344 billion in January, making February the busiest month for new issuance since May 2011. According to New York Federal Reserve data, dealer positions in corporate securities with a maturity longer than one year reached a multiyear low the week ending February 22, 2012. In March, with dealer positions rising, borrowers remained active but balances fell as quarter end approached. Market participants focused on risk positions, and returns of specials were heavy ahead of month end. Clients also increased their selling of positions and loan recall volumes increased as March progressed. The financial sector, combined with the energy and communications sectors, comprised a little over half of bonds on loan.

We do anticipate balances to rise from current levels in the second quarter. At quarter end, domestic corporate bond issuance was approximately one third of J.P. Morgan Securities Inc.’s 2012 estimate of $700 billion. Despite a slowing new issuance calendar going forward, if year-to-date trading averages of $13.4 billion of high grade corporates and $5.5 billion of high yield corporates hold, borrowers will likely remain active covering their cash trades.

International

Balances and volumes in the international fixed income lending book remained constant throughout the first quarter of 2012, but slightly off the highs seen at the end of 2011.

Demand for high quality sovereign bond collateral remained, but spreads between core and peripheral European sovereign issuers were greatly reduced as efforts to contain the crisis started to take effect:

The two European Central Bank (ECB) long term financing operations in December and February were “game changers” in the sovereign repo markets – the increased liquidity surplus will likely keep rates low and stable for the foreseeable future. At the ECB’s second three year LTRO, the central bank allotted €529.5 billion of liquidity, with demand from 800 banks. The take up was higher than the December operation (€489.2 billion) with the increased number of bidders suggesting that a number of small banks participated, which may be seen as encouraging by the ECB, especially in terms of financing the real economy. With new net borrowing around €313 billion, more than 90% of the ECB liquidity operations are in the two three year LTROs.

In February, Eurogroup finance ministers finally agreed on the €130 billion rescue package for Greece. The main point of discussions was the troika debt sustainability analysis, which had seen Greek debt to GDP at 129%. Finance ministers agreed to bring this down to 120.5% by a variety of measures such as the ECB forgoing profits on its SMP and NCB investments portfolios, the private sector taking a higher nominal haircut (at 53.5%, up from 50% previously) and lower interest rates on E.U. loans to Greece with an interest rate margin of 150bps.

Euro zone ministers agreed at the end of March to increase the combined lending ceiling of the EFSF and the ESM to €700 billion (from €500 billion). "All together, the euro area is mobilizing an overall firewall of approximately 800 billion euros, more than 1 trillion dollars," the Eurogroup statement said. The higher number was arrived at by adding in bilateral loans that euro zone countries granted to Greece under a first bailout, money disbursed by the EFSF and from a smaller third fund controlled by the European Commission.

Volume in the corporate bond markets started high, but the number of shorts decreased by 10-20% over the quarter. European financials had been in high demand in the repo markets during January, with many trading special, but the credit market rally since the start of 2012 has decreased the appetite to hold shorts.

Looking Ahead

With improving market conditions and outlook, we expect the spread between credit products, government bonds, agencies and agency MBS and the spread between various sovereigns will remain compressed. This will lead to narrower spreads in government bond trades collateralized by securities collateral. Demand for Treasuries may increase with Dodd-Frank and Basel regulatory changes requiring dealers to hold more risk free assets. For corporate bonds, an active trading environment, along with a higher supply of high grade and high yield bonds, should lead to an increased demand and higher balances.

This publication by J.P. Morgan Worldwide Securities Services is intended to inform our clients and friends of developments in the industry and to provide information of general interest. It is not intended to constitute accounting, legal or tax advice and should not be relied upon as such.