Front-end agencies tighten as yield curve steepens; Fannie Mae sells $4 billion three-years

By Kenneth Lim

Boston, July 9 - Agency spreads tightened on the front end Thursday as Treasury prices eased from the day-before rally, while Fannie Mae priced $4 billion of three-year Benchmark Notes.

Two-year agency spreads were in by about 3 to 4 basis points, while three-years were unchanged, said Thomas Urano, principal and senior trader at Sage Advisory Services Ltd. Five- and seven-year spreads were slightly wider on the day, while the 10-years were flat to 0.5 bps wider.

"The front end of the curve did well," Urano said. "The credit curve was steeper on the day today."

The shorter-term securities were doing better largely because of confidence in the demand generated by the Federal Reserve's buying program, Urano said.

"At these levels, with the government doing so much support...people are somewhat comfortable with the backing of those notes," he said.

Fannie Mae deal oversubscribed

Fannie Mae priced $4 billion of three-year 1.75% bullet Benchmark Notes in line with price talk at a spread of 32 basis points over Treasuries. The issue yielded 1.775%.

The deal was oversubscribed with orders received totaling about $5 billion, a market source said.

The Fannie Mae offering came in the wake of a sharp rally in Treasury yields on Wednesday in response to a strong auction of 10-year notes.

"That was actually nice to see, the craziness that we saw [on Wednesday]," the source said. "It didn't mess with the offering."

Fannie Mae said 70.4% of the new notes went to U.S. buyers, with 17% going to Asia and 4% to Europe.

Central and commercial banks took a bigger than normal chunk of the notes offered, according to data by Fannie Mae. Central banks, which have bought 17.8% of the non-callable Benchmarks so far this year, took 26.4% of the new offering. Commercial banks bought 23.4% in the new offering, relatively more than their year-to-date 13.5% participation in the offerings.

"It's been reasonably well discussed that the banks have more cash right now than they have demand for the cash," the market source said.

Fund managers remained the biggest buyers of the new Benchmarks, buying up 41.2% of the Notes offered.

Thin supply, propped demand

The source said that the market was probably not reading too much into the fact that Fannie Mae skipped both its Benchmark announcements in June, noting that the agency had planned more announcements in its 2009 calendar than it usually does.

"We've never had multiple announcements in a month," the source said.

The agency, along with Freddie Mac, also faces much less need to raise such capital.

"The cost to issue debt and the return on the mortgages, it just doesn't work anymore," the source said. "So they're not growing their portfolios even though they have the ability to do so."

The picture on the demand side continues to be heavily influenced by the Fed's buying.

"I don't think spreads are at a level they'll be naturally," the source said. "If a buyer shows up every week, which the Fed is doing, it's definitely a factor. But it's a stabilizing force. For the two- and three-years, we passed the equilibrium maybe 10 to 15 bps ago."

The spread tightening that is supported by the Fed's buying may render agency paper a little too rich, the source noted.

"I think you're having potential issues attracting capital," the source said. "We didn't have problems with this [Fannie Mae] deal, but then again we didn't have a $15 billion float."

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