Agencies narrow on month-end index extension buying; holidays, supply drought may support spreads

By Kenneth Lim

Boston, June 30 - Agency spreads tightened on Wednesday on a flurry of last-minute buying as accounts sought to match indexes before the close of the month.

Bullet spreads closed about 1 to 1.5 basis points tighter, continuing the market's outperformance of both Treasuries and swaps this week.

"Index fund managers have had to match the index, which I think was 0.07 to 0.09 points better, so that led to some tightening," said Michael Skinner, an agency trader at Wall Street Access.

The callable market was unusually quiet after strongly dominating activity the week before. That slump in callables could be partly attributed to investors focusing more on bullets, Skinner said.

"Last week we had a lot of action in callables," he said. "Today was centered on benchmarks."

Of the callables that were active, step-up structures remained the "flavor of the day," he added.

"People are shying away from fixed callables at these absolute yield levels," Skinner said. "They want some kind of protection in the back end."

Existing paper continues to be called at a brisk pace, however, and that should help the market segment to rise back to the forefront once the distractions of the month's end and the coming long weekend fade, he said.

"Frankly, there's only so many Aaa names out there, and four out of five are [government-sponsored enterprises]," Skinner said.

Strength could last

Skinner expects the current tightness in the market to persist over the long weekend.

"There's no supply until July 7, so spreads should hold in pretty well the next couple of days or so, unless the markets start to melt," he said.

Nevertheless, the market is on the tight end of the valuation range at the moment, and a correction could be around the corner once the new week begins.

"I'm not expecting a pullback with the holiday coming up," Skinner said. "I'd expect activity to be somewhat muted in the next day or two, but in the next week or two, there should be some relief."

Investors are entering the next month and the third quarter of the year focused on figuring out the willingness of the market to take on risk, Skinner said. He noted that the past few weeks have been marked by poor equity markets and a steady march toward the safe haven of Treasuries.

"It seems that the risk appetite that's been around since last March has abated somewhat, so people will be looking at people's appetite for risk," he said.

Risk, supply top issues

Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott, said the agency market was mostly unchanged in terms of spreads for the quarter. But that was a decent performance given the run-up in Treasury prices.

"Overall it looks like it's been a reasonable quarter for the agency market without a lot of changes in spreads," he said.

"The biggest trend evident was the rally in Treasury yields from the end of April to the end of June, and that's really been the overwhelming driver of performance. Spreads played a very minor role."

The agency yield curve has followed the lead of Treasuries and flattened slightly, although some slight widening in longer-dated paper has offset some of that flattening.

Callable issuance continued to be heavy, especially from Fannie Mae and Freddie Mac, LeBas said.

"I believe it reflects the uncertainty over mortgage prepayments," he said.

The third quarter will likely continue to see limited supply, and most of the new deals will probably come in the five-years-and-shorter sectors.

"As a result, we're a little optimistic right now about the intermediate to longer term on spreads," LeBas said.

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