Outlook 2011: Agencies could tighten versus Treasuries on lower supply, possible Fed easing

By Kenneth Lim

Boston, Dec. 31 - The agency market could tighten slightly versus Treasuries in 2011, while callable demand is expected to be mixed as redemption rates slow down, market analysts and traders said.

The past year could be seen as a transition year for agencies, marking the end of the financial crisis in 2008 and 2009 and the start of the slow recovery period going forward, an agency trader said.

In 2008, the U.S. government placed Fannie Mae and Freddie Mac under conservatorship. In 2009, Treasury gave its full backing to the two agencies until the end of 2012 and the Federal Reserve's first round of quantitative easing took full effect.

Those kinds of game-changing headline events were mostly absent in 2010, although the agency market continued to operate under a cloud of uncertainty about the economy and the future of Fannie Mae and Freddie Mac.

"We started 2010 and in mid-April people were talking about tightening by end of the year," the trader said. "Then the market traded off and it proved to be an illusion. 2010 was kind of a transition year, getting back to normal. GSEs came to market with regular spots of issuance, but we saw a glimpse of the future with more passing on deals and reopenings, a symptom of having [been] forced to trim portfolios."

"We kind of had one foot in the past and one foot in the future," the trader said. "We came out of the mess we were in in 2008 and 2009 and had a relatively straightforward year in 2010 with no big tape bumps, but getting a glimpse of what may lie ahead."

Solid year for agencies

In light of the underlying changes and uncertainties in the market, agencies had a pretty good year overall, the trader said.

"Given the uncertainty, it's been a very, very solid year for agencies," the trader said. "It's been a one-way trade toward buying, and it's only in the last three to four weeks that we've seen any big selling. Agencies have traded tight, and I'd say 2010 saw agencies grow even closer to the underlying Treasury debt. It's interesting how you've seen some sovereign debt struggle versus agencies, which trade tight but has been recognized as having explicit backing from the U.S. government."

Bullet spreads tightened for most of 2010, hitting historical lows at the start of the fourth quarter before easing off as concerns about Europe pushed swap spreads wider, wrote Barclays Capital analysts Rajiv Setia and James Ma in a report.

But spreads are still relatively close to the lows of the range, with the two-year spread versus Treasuries around 12 basis points near the end of the year. The three-year spread was around 20 bps, and the five-year spread was around 25 bps.

"We expect agency spreads to hew closely to these levels over the course of 2011, slowly moving tighter still," the analysts wrote.

Risk-on trade takes toll

Janney Montgomery Scott chief fixed income strategist Guy LeBas had a slightly contrarian take on the 2010 market for agencies, noting that agencies appeared to underperform most other fixed income instruments because of risk-on trades.

LeBas reckoned that agencies also underperformed Treasuries slightly because the Fed stopped buying agency bellwether benchmarks in March 2010.

The strategist is underweight on agencies in 2011 on expectations of higher risk appetites, unless there is a strong back-up of short-term rates. Spreads should tighten slightly versus Treasuries as the spread curve flattens and accounts chase yields, LeBas wrote. But versus swaps, he expects agencies to widen.

"Agency performance will trend far closer to the Treasury sector than any other major asset class, although decent technicals in agency supply have the potential to create a modest spread tightening as 2011 progresses," he said.

Mary Ann Hurley, a trader at D.A. Davidson & Co., thought that spreads could actually widen if interest rates rise.

"Given that interest rates are still relatively pretty low, I think that if interest rates rise, as many of the economists out there are projecting them to go, I think that should cause spreads to widen out for agencies from where they are now," she said

Shifting demand

Domestic investors have also displaced foreign money in longer parts of the yield curve, the Barclays team said.

"By all accounts, some key foreign and official segments of the agency investor base essentially staged a buyer's strike on any debt maturing after 2012 due to discomfort with the credit," the analysts wrote. "However, this void was filled smartly by domestic investors."

Foreign interest in longer agency maturities is likely to remain thin in 2011, but the domestic segment of the market should grow. Banks should have more cash in their coffers to invest in safe, high-yielding assets, while reinvestments of money currently in the expired Temporary Liquidity Guarantee Program will support domestic demand for agencies, the analysts added.

December curveball

A look back at 2010 will also reveal a December that many investors would probably like to but will not easily forget.

Absolute yields rose sharply in December as investors fled Treasuries on fears of a stronger-than-expected domestic economy and higher inflation. The fact that agencies outperformed Treasuries was only a slight consolation because in terms of prices, Treasuries and agencies lost most of their gains from earlier in the year in just one month.

"December was a really rough month," one government bond trader said. "Everything leading up to December and the second half of November was doing really well, then in just a few weeks we erased 11 months of gains."

The sharp volatility that ended the year was also trying on callables, with many secondary issues pushed out of the money and investors facing a tough time hedging.

"When there's an uptick in volatility, spreads on callables versus bullets widen, and when it widens, a lot of people don't have it hedged away," the trader said.

Quantitative easing

The Fed's initial easing policy of buying Treasuries, agency debt and agency mortgage-backed securities expired in March 2010, leaving behind complaints that the central bank may have done too much in agency land by drying up liquidity.

Quantitative easing came back in November with a $600 billion program, although round two targeted only Treasuries. Agency spreads were relatively unmoved by QE2 and yields, in line with Treasuries, did not fall by much.

But quantitative easing is expected to keep agency spreads tight in 2011 because the policy will pump more cash into the balance sheets of banks, which will prefer to put them in higher-yielding assets. Noting that banks raised their agency debt holdings during the first round of quantitative easing, the Barclays analysts expect the trend to repeat in round two.

"With QE2 in its infancy, cash on bank balance sheets should grow from $1.0 trillion today to about $1.4 trillion by June 2011," the analysts wrote. "We would expect the subsequent second wave of cash to flow through in some amount to agency debt demand."

Rise of the step-up

The callable market also had an active year, with step-up structures in particular growing at a fast clip as investors sought to protect themselves against higher rates.

Investors chasing after yields in the low-rate environment of 2010 were attracted to the potentially higher coupons offered by callables. Step-ups, in particular, addressed concerns that rates would rise in the future.

"Step-ups probably will still see interest in 2011 because they offer a defensive mechanism for bondholders," Hurley said. "People like that especially in the current environment with uncertainty about rates. I think step-ups will continue to be a favored investment vehicle."

There are some segments of the market that are less keen on the structures, however. The agency trader said one-time call structures seemed to be a more efficient way to lock in higher rates.

LeBas said multi-coupon step-up notes will fare worse than one-time call structures and recommends par and premium straight callable paper in 2011 if rates rise.

"In each of the rising-rate scenarios considered...the shorter duration of the premium 5-year no-call 1-year offers a greater degree of protection than lower coupon callables," LeBas wrote. "In the event 2011 rate increases exceed our expectations, the premium 5-year no-call 1-year also outperforms the 5-year bullet."

Investors who expect rates to rise by no more than 45 bps to 55 bps in 2011 and to fall in the second half of the year should buy three-year non-callable six months or five-year non-callable six months structures, the Barclays team wrote.

Three-year non-callable one year or five-year non-callable one year notes, however, could slightly outperform if there is a bigger sell-off in rates. The main risk is significant underperformance if bond prices rally and the notes are called away.

Call redemptions to slow down

A major reason for 2010's high gross issuance volumes of callables was that issuers were calling paper as soon as they could to take advantage of low interest rates.

But that trend could diminish in 2011 in light of the recent rise in absolute rate levels, the agency trader said. If redemptions slow down, that could reduce demand for new callable paper.

"If rates go higher and callable agencies don't get called, that will add to pressures on spreads," the trader said. "You're interested in printing and buying and selling current coupons and you've got paper in your hands that haven't been called like you expected, and you can't do anything until you take care of that."

Liquidity squeeze to continue

Liquidity will probably continue to be an issue for the agency market, especially in longer maturities, as supply continues to shrink.

"It's become a less liquid environment five years and out simply because they haven't been issuing there," the trader said. "We haven't had a new 10-year since March of 2009. Fannie Mae and Freddie Mac each did two five-years this year, but out beyond that is just season paper. Liquidity is going to be the biggest challenge out past five years."

The risk for the market is that it becomes harder to be efficient when liquidity is low, the trader said.

"If some of those bonds are put away, you can get one big buyer who can really disjoint the market," the trader said.

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