Agency spreads follow swaps wider amid Europe concerns; callables still drawing investors

By Kenneth Lim

Boston, May 14 - Agency spreads widened slightly on Friday as a flattened swaps curve pulled the market outwards.

Bullet spreads expanded by about 1 basis point across the yield curve, said Mike Goldman, head of agency trading at Guggenheim Partners.

"It was a lot related to the swap curve, because of what was happening in Europe," he said. "Libor was bid higher, and when Libor is bid higher, you get a flattening of the swaps curve. Swaps in twos and threes were higher, fives were out a little, 10s were in a little.

"So agencies get drawn a little bit into them and you have a generally somewhat weaker tone for agencies."

Despite the widening versus Treasuries, agencies outperformed swaps, as they have been doing for the past two weeks, Goldman added.

Subdued volumes

Trading volumes remained weak on Friday, as they have been all week.

"I think the important thing is flows have been very subdued," Goldman said.

The creditworthiness of agency debt is perceived as extremely strong at the front end - reflected in tight spreads - so concerns that cause volatility in other spreads products do not hit the agency market as much, Goldman explained. But that tightness also works against the trading appeal of agencies.

Skittish investors looking for safe havens will go straight to Treasuries because there is "better liquidity there" compared to agencies. And investors who want better yields and are looking to move out on the risk spectrum can find better value in corporates. These days, agencies seem to appeal the most to investors who only need to tweak their portfolios.

"They're not really moving that much for the credit," Goldman said.

Interest in agencies has also dried up with the current supply drought.

"You combine that with a lack of supply, and there isn't a whole lot of supply in agencies," Goldman said. "And the Fed's taken out a big amount of the market."

Callables see action

The one bright spot for the agency market is in callables, despite a slump in activity over the past two weeks because of the current demand for safer investments.

"The thing that is still trading is callables," Goldman said.

The steep yield curve creates a nice environment for callables, which offer better yields than straight bullets. And among callable structures, step-up notes hold the most appeal.

"We have a steep yield curve and a Fed that's just delayed even further now the possibility of a rate hike...as long as they're on hold, you might as well buy agency callables to pick up the yield," Goldman said.

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