Agencies tighten on Treasury weakness, big long-end buying; callable issuance could slow

By Kenneth Lim

Boston, July 27 - Agency spreads continued to tighten on Tuesday as Treasuries weakened further and some big buyers were seen at the longer end of the yield curve.

Bullet spreads narrowed by about 1 to 2 basis points versus Treasuries across the curve, with longer-dated spreads outperforming shorter issues. Part of that tightening came from Treasury yields, which rose across most maturities on Tuesday as new supply came to the market.

"All spreads, particularly in the long end, have come in," said Mike Goldman, head of agency trading at Guggenheim Partners. "Spreads have been tightening over the last couple of days, and today's a continuation of that."

Callable issuance picked up again after a slump on a slow Monday.

"People are reaching for shorter lock-out callables that have some yield in them," Goldman said.

Trading volumes were also an improvement from Monday, which was extremely quiet.

"It's a little bit better than yesterday," Goldman said. "You'd kind of expect that because it was a Monday."

Looking ahead, Freddie Mac is on the calendar with a Reference Notes announcement on Thursday. Goldman expects a small deal at the front end.

"Based on past history and needs, the expectation is they don't have a lot of needs," he said. "So my guess would be a reopening of the two-year or three-year."

Back end buying

Spreads were also pulled in by the appearance of some big buyers in the long end of the curve, Goldman said.

"There's been some large buying in long end agencies, those maturing in 2030, and there has also been other buying across the curve," he said.

Usually, such buying would only have limited impact on market spreads, but the agency market has been facing a bit of a liquidity crunch recently, Goldman explained.

"Because of the Fed buying programs over the last few years, those have just stripped so much liquidity out of the market, so when you see big buyers come in, there's nothing pressing back against that, and so it kind of distorts the market, and movements have become more exaggerated," he said.

Callable pace to slow

The furious growth of callable issuance could slow down in the second half of the year after heavy redemptions and a low interest-rate environment increased primary volumes in the first six months, said Janney Montgomery Scott chief fixed income strategist Guy LeBas.

"Their maturity schedule, other than June and July, isn't that big," he said. "But they do have a lot of older callable coupons that are hitting their first call dates...Their funding needs are driven by calls of outstanding issues rather than demand for new issues or balance sheets."

His comments came as Fannie Mae reported that callable issuance rose 30% year on year in the first half to 2010.

Fannie Mae issued about $149.1 billion of callable paper in the first six months of the year, representing about 73.5% of its total $202.8 billion in debt issuance for the period.

"Callable activity was particularly robust in the months of April and June 2010, when the market experienced a rally in long-term rates and concerns over European sovereign risk may have led investors to invest in long-term agency securities that typically offer higher yield than comparable Treasuries," Fannie Mae stated in its report.

"Furthermore, Fannie Mae sought to replace the high volume of callable redemptions of approximately $126 billion during the first half of 2010 to offset the inherent negative convexity and volatility exposure in its mortgage portfolio."

The Fannie Mae data match similar storylines at the other agencies. Freddie Mac issued $124.4 billion of medium-term-note callables in the first half of 2010, up by 3.6% year on year, while Federal Home Loan Banks issued $111.5 billion of fixed-rate callables in the first two quarters.

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