Outlook 2010: Agency supply likely to shrink in 2010; callables, step-ups to remain popular

By Kenneth Lim

Boston, Dec. 31 - The primary agency market could slow down in 2010 as issuers' funding needs continue to decrease, market sources said.

Bullet issuance volumes will probably decrease as Fannie Mae and Freddie Mac try to trim their portfolios, although Federal Home Loan Banks could seek to extend the length of its obligations in term-out deals, analysts and traders said.

On the callable side, the step-up trade looks to remain a popular structure for investors concerned about rising interest rates.

Front-loaded 2009

Fannie Mae, Freddie Mac and FHLB issued about $1.1 trillion of bullet and callable agency notes in 2009, excluding discount notes, according to data from the three agencies.

On a year-on-year basis, issuance volume was only about 2% higher than in 2008, but a closer look reveals of story of two halves in 2009.

Most of the volumes came in the first half of the year, with deal sizes hitting records as Fannie Mae and Freddie Mac tried to term out their liabilities.

One of the largest deals in recent history by an agency came in February, when Fannie Mae issued $15 billion of two-year Benchmark Notes due March 2011 at a spread of 68 basis points over Treasuries. The same month, Fannie Mae also offered $7 billion of five-year Benchmarks, and then another $9 billion of five-year Benchmarks were sold in March.

But the market is "ending the year here with significantly reduced demand from an issuance standpoint," said Barclays Capital's head of agency trading, Michael Graf.

With their funding needs mostly met and the prospect looming of having to trim their portfolios in 2010, the agencies slowed down their issuance drastically in the second half of the year.

At Freddie Mac, for instance, the agency hit a first-half high of $10 billion in an offering of three-year Reference Notes in February. But in the second half of 2009, the largest bullet issuance was a $4.5 billion offering of three-year Reference Notes in August.

"Term funding needs were massive early in the year driven by the need to reduce reliance on short dated funding," wrote RBS Securities' head of agency strategy, Margaret Kerins, in a note. "In the first three months of the year, the GSEs issued $400 billion in bullets, callables and floaters versus a $150 billion average of the prior two quarters.

"The terming out pressure subsided in the second half of the year and the GSEs were able to richen funding levels dramatically."

Dealer landscape changes

Graf also noted that the landscape of primary dealers has also changed, with a number of players gone from the marketplace because of the financial crisis. Underwriting in 2009 was dominated by JPMorgan and Barclays simply because of the uncertainty that gripped the markets at the start of the year, although 2010 could see some normalization.

"The percentage of market footprint [among primary dealers] has veered dramatically this year," Graf said. "The disparity between the top slot and down five to 10 people, this year you've seen a pretty strong tiering of the marketplace with JPMorgan and ourselves dominating the underwriting market."

Another trader said the second-half slowdown did not come as a surprise.

"They're not raising money just for the heck of it," the trader said. "The housing market is still recovering, and they're already thinking about cutting their portfolios in 2010, so there's really no need for them to issue the $6 billion or $15 billion kinds of deals at the start of the year. I think everyone knew this was going to happen."

The tightening supply even had an effect on the secondary market, the trader added.

"I think it definitely played a role," the trader said. "There was a lot of demand this year for agencies and not a lot of supply in recent months to meet that demand, which is why spreads have become so tight."

Callable attraction

While bullet issuance died down in the second half of the year, callable issuance went the opposite direction and surged as investors began to seek higher yields amid concerns about rising interest rates.

"Callables dominated gross issuance in 2009 at $571 billion, repricing the majority of the callable market throughout the year," RBS's Kerins wrote. "Despite the heavy gross issuance, net callable issuance was negative for most of the year and only began to catch up when redemptions slowed and a scramble for coupon maintained demand."

She expects net callable issuance to end the year flat.

The agency trader said the agencies, especially FHLB, had strong incentive to issue callables in the second half of the year because interest rates continued to scrape the bottom despite growing concerns about inflation.

"Most of the callables are replacing old notes that are being called, so they're not really a big change from a funding standpoint from the issuers," the trader said. "They're calling all the notes when they can because rates were so low.

"The other half of that equation is people were happy to buy up the new notes because they could pick up better yield."

Investors who expect interest rates to rise in 2010 also drove strong demand for step-up structures, which offer coupon raises if the notes are not called. One trader felt that the interest in step-ups will continue into 2010.

"It's a very durable trade," the trader said. "It's a bear market trade. A lot of people expect the Fed to raise rates in 2010. Whether it's Q2, Q3, Q4, nobody knows, but one thing's for sure: The skew is for rates to go up next year."

"With a step-up, essentially you win either way," the trader added. "Either you get great carry...if the bond gets called, or if it doesn't get called, you get compensated for the extension risk."

Fewer calls in 2010

But callable issuance could face a hurdle in 2010 from having less maturing notes than in 2009, Kerins said.

"The amount of callable agencies maturing next year is marginal, so activity will be dependant on the path of interest rates and the potential for callable issuance to replace floating-rate runoff," she wrote. "Call activity is likely to fall in 2010 as rates stabilize and eventually rise compared with heavy levels over the past three years averaging $500 billion."

Callable performance in the year ahead will essentially hinge on the Fed's interest rate actions, Kerins said.

If rates stay unchanged, callables should outperform bullets because of excess returns provided by the spread and roll down the curve, she explained. If rates fall, bullets will do better than callables. Timing will determine the relative performance of callable step-up and bullet structures if rates increase.

Bullets in the sights

With the agency market facing disappearing demand from the Federal Reserve and foreign central banks, all eyes are on the supply situation in 2010 for a sense of where spreads are headed.

"The amount of supply that's going to be hitting the market will be a big theme," Graf said.

Kerins expects issuance of agency bullets with maturities of two years and beyond to fall by $84.2 billion in 2010.

"The base case scenario for supply assumes that Fannie Mae and Freddie Mac's retained portfolios decrease by 10% and FHLB advances decrease by 5% by the end of 2010," she wrote.

If Fannie Mae and Freddie Mac grow their portfolios up to the $900 billion cap or if they need to fund loan modifications purchased out of trust, however, bullet issuance should increase in the year ahead, she added.

Brian Perry, investment strategist at Chandler Asset Management, also sees issuance declining in 2010 and the next few years. The tightening supply could help valuations, but it could also push investors toward other alternatives.

"We still need to own something," Perry said. "I don't think that's an instrumental problem yet, but we're talking to our clients just to make them aware where the day may come [when we may have to decrease our allocations]."

FHLB's turn

Graf also thinks that 2010 could be a year for FHLB to issue more term debt to reduce its exposure to short-term discount notes, a move that Fannie Mae and Freddie Mac already did in 2009.

"The Home Loan Banks System, their advance books continue to contract," Graf said. "They need to get discount notes outstanding down and term debt up."

The trade would make sense for FHLB with rates as low as they are at the moment, he added.

"The businessman would say if you need the funding, and you can take the term debt, you should take it," he said. "The market is providing the incentive as well to do that term out trade."

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