Agency spreads narrow; Fannie Mae talks three-year Benchmark Notes at Treasuries plus 31 bps

By Kenneth Lim

Boston, March 10 - Agency spreads tightened on Wednesday as the short end of the yield curve continued to strengthen, while Fannie Mae announced an offering of three-year Benchmark Notes.

Following comments last week by U.S. Rep. Barney Frank that raised concern about the government's long-term support for Fannie Mae and Freddie Mac, the agency yield curve has steepened as longer-dated paper underperformed.

That trend continued on Wednesday as two-year bullet spreads narrowed by about 2 basis points, while out in the 10-year sector spreads were in by about 1bp, an agency trader said.

"We've had a steepening of the yield curve in the last couple of days," the trader said. "The last couple of days twos have been tightening, and tens have been the same or wider."

In terms of trading volumes, market activity was decent, the trader said.

"It's been reasonably active," the trader said.

Callable trade to persist

Callables continued to see heavier trading as investors sought to take advantage of falling volatility and persistent expectations of lower interest rates.

"We saw good buying in callable structures," the trader said. "Volatility's already down probably 10% to 15% over the past few weeks, so clients have already made tons of money on this."

Volatility could drop even further and could fuel callable demand for another two weeks to a month, the trader added.

"It's a synthetic way to get short volatility, and there's more carry in it," the trader said. "I would expect to see clients continue to buy this through the end of March or early April. April 28 is the next Fed meeting after this one on [March 16], so I would expect to see volatility a little lower during that time."

But the trader said callables are no longer cheap, "so I wouldn't be loading the boat right now." When the Federal Reserve enters a rate-raising period, the callables will also suffer.

"When we get in a rising rate environment, these are going to get destroyed," the trader said. "But for now it's a good trade."

Fannie Mae to offer three-years

Fannie Mae plans to price a benchmark-sized offering of new three-year Benchmark Notes on Thursday, with price talk at a spread of 31 bps over Treasuries, market sources said.

The size of the deal has not been set, but it is expected to be at least $3 billion.

Barclays Capital Inc., Deutsche Bank Securities Inc. and J.P. Morgan & Co. are the lead managers.

The trader said the deal should do well, although it is priced aggressively with only a slight concession of about 1 bp to surrounding issues.

"It's pretty flat to the curve, so not much of a concession," the trader said.

But demand in the three-year sector is strong, so the offering should still do well, the trader added. But the market should not expect a repeat of Freddie Mac's three-year offering a week ago, which arrived at $5.5 billion.

"At that [pricing] level I don't think it'll be that big, maybe $4 billion," the trader said.

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