Bond Market Update
by Brad Tottle
Convexity Convulsions
August 11, 2008
As expected, the Fed left the overnight benchmark rate unchanged last week at 2%. The statement seemed to move back toward a neutral stance in terms of risks to growth and the threat of inflation. Gone was the talk that risks to growth “had diminished somewhat”, which was present in the last statement. Considering that since the last meeting the employment picture has weakened, consumer spending was unimpressive (even with the stimulus checks), the GSEs solvency came into question, credit conditions remained as tight as a snare drum, and we witnessed the 3rd largest bank failure in U.S. history, you can start to understand why they dropped the encouraging phrasing.
If you just looked at the net yield change from the last week you might conclude that it was a quiet week in the bond markets but nothing could be further from the truth. Both of the GSE’s reported earnings that were brutal but what sparked more of a reaction was talk of slowing/trimming the growth in their respective retained portfolios. Fannie Mae will no longer underwrite or guarantee Alt-A loans and slashed its dividend, a move that seems to portend more capital raising away from Capitol Hill. Mortgages were heavily pounded along with Agency paper and the hedging-related spillover hit the curve and swaps. The mortgage market has been perplexing of late since it is operating out of its normal element. Normally, in a period of falling interest rates prepayment risk rises, thus the duration of a mortgage portfolio shortens, inducing increased need for duration. This can be done either by outright purchases of long-duration treasuries and agencies or by entering into receive-fixed swaps. Swaptions are also used as they carry positive convexity, offsetting the negative convexity caused by a drop in duration, the most popular variety being 3month/10Year swaptions, which give the buyer an option to enter into a 10-year swap in 3 months.
Anyone who trades Treasuries either directly or as a hedge has experienced the quick, amplified movements that come when the mortgage crowd enters the market for hedging needs. Convexity hedging thus causes buyers to buy as yields fall, which in turn pressures yields lower, forcing more buying. (Remember Greenspan’s conundrum of an inverted curve amid Fed tightening? It was not just foreign buyers of Treasuries bidding the back end of the curve but the enormous amount of duration buying from mortgage servicers that accompanied the huge refinancing boom.) This forces other market participants to react to the shift. Pit traders are forced to react and corporate traders must adjust their hedges and spreads, both of which tend to push the initial move further, faster.
What is perplexing at the moment is that while interest rates on Treasuries are lower, mortgage rates have been climbing (hence the widening in Mortgage Spreads) and credit creation has slowed, both of which tend to slow prepayments. Prepayments are not what the mortgage servicers are worried about this time around, delinquencies and defaults on the underlying collateral are. I’m pretty sure a little prepayment would be welcomed by the GSEs at this point! This has led to huge intra-day selling in Treasuries as the GSEs sell duration anyway they can. Historically another option to Treasuries/Swaps/Swaptions is to offset a change in duration in its assets by lengthening the duration of liabilities by selling debt. The GSEs have done this, but at a higher cost to historical levels. And so they are sellers of duration right now…at the exact same time some of their biggest buyers (overseas) have pared back purchases, amplifying the downward price momentum. Still, for longer-term investors who can stomach some statement pricing volatilities and extension risk, the yields are historically attractive. There was some decent, albeit tentative buying on Friday in the complex but after a huge widening. For those who want to avoid the extension risk and want a little more yield, the senior debt of the GSEs has also widened out to attractive levels, especially given the move towards a more explicit guarantee by the Government from an implicit one. Again, anyone looking to bottom tick this market is in for several bouts of whiplash but the value is starting to stand out.
Now I know I am biased, being a bond nerd and all, but if I had to pick a side of the capital structure to be in for the next few years I’d favor the senior debt over the equity, at least in the front-end of the curve for the financials. I might miss out on the huge recovery I have been told is coming in the equities since last quarter but I’ll take 4.5-6% on higher grade names while they de-leverage over the next 2-3 years. The bet, of course, is that the issuer will still be around to pay so stick with the financials the Fed has blessed with additional liquidity options; the GSEs, commercial banks, and primary dealers. (Please note: any trade involving the financials should be accompanied by two shots of MaaloxÒ per trading session.)
In Treasuries, TIPs are starting to look attractive but given the odds of a slowing in growth and an ebb in inflation pressures, there is the chance that they get even cheaper. As a side note, I got a chuckle last week hearing some market watchers note that crude had technically entered into a bear market. Isn’t it still up over 59% from a year ago? I’m not an oilman but I give it till the end of this sentence to gain back some ground. Market breakevens have fallen since the end of June even as CPI has risen on a year-over-year basis bringing 10-year breakevens back towards 2.25%. Any break below 2% would look very attractive compared to nominal bonds (TIPs carry phantom income so they are best suited for tax-deferred accounts). Corporate inflation-linked bonds look rich at current levels, especially considering that this time next year we will be working off of a high base and so the yearly percentage reading should come in lower. Still, year-over-year inflation prints will likely stay elevated for the next few months. This chart shows 2, 5, and 10-year breakeven rates along with the year-over-year change in CPI.
Speaking of CPI, we get the data from July this week on Friday along with other inflationary data, including import prices (Wed) and the prices paid/prices received component from the Empire Manufacturing Index (Friday). Also of interest will be the Senior Loan Officer report, which should be sub-titled; “Honey, I Shrunk the Balance Sheet”. Fed speakers come in the end of the week with Minnesota Fed President Stern (voter) on Thursday and Chicago Fed President Evans (non-voter) speaking on Friday. Outside of cash management issuance, fresh Treasury supply will be light. As for last week’s refunding of 10s and 30, the surprising success of both auctions was a large driver of the rate rally late last week. Both auctions went off below when-issued screen levels, the tails were relatively small, and indirect bidders made their presence felt. The 30-year auction really caught some accounts by surprise as a tidal wave of buying ensued post-auction and carried into the early part of Friday’s session. Much of the activity came from arbitrage players who looked to quickly close out steepening bets. The 2y/30y curve spread narrowed nearly 9 basis points on the follow through buying on Friday. Technical players quickly got stopped out as the forced buying from the steepening-unwinds pressured shorts set into the supply. The mortgage crowd also unwound some hedges due to the tentative nibbling in mortgages/agencies I mentioned before. I have discussed in the last several weeks a soft ceiling on the long-end that remains intact. As long as nominal GDP falls, nominal yields should follow. You don’t need a weatherman to tell which way the wind blows (thanks Bob!) and you don’t need to be a realtor to know that long-term rates have to maintain their low-hanging fruit status if we truly want the housing market to stabilize.
Chart of the Day: 3-Month LIBOR/ Overnight Indexed-Swaps Spread: This chart shows the difference between the rate at which banks will loan money to each other for a 3-month period (3-month LIBOR) and the swap rate on an overnight indexed-swap (OIS). The OIS involves lower counter party risk because the only payment at risk is the net interest profit on the swap, i.e. the difference between the fixed rate and the indexed rate, usually set to effective Fed Funds, which is paid at the end of the swap. LIBOR rates remain elevated since they involve a higher degree of counter party risk in that the total principal amount of the loan is at risk. Over the first part of this decade the spread averaged fewer than 12 basis points with the widest spread of 38 basis points, half of the current spread of 76. We have seen higher readings, like when Bear Stearns announced it had to bailout several of its hedge funds, Countrywide insolvency concerns arose, Bear Stearns underwent an emergency buyout by JP Morgan (They got by with a little help from the Fed) and concerns over the validity of LIBOR rates became a hot topic. This spread has been rising over the last several weeks showing a tightening, not an easing in credit conditions. Folks, in simplest terms, if the banks are lending less to each other then they are probably not in any rush to lend to us. And if they do, the spread will be wider than historical levels. Next stop on the Deleveraging Express? The American Household.
-BDT
Credit Crunch Over? Hardly
August 4, 2008
Ah, Fed Week. Given the increased volatility over the last week (and to a greater extent, July as a whole) I am actually looking forward to the hush over the street that tends to precede the FOMC’s two-day meeting. After working through yet another massive wave of mortgage-related deleveraging, and the subsequent after effects in Treasuries and thereby spread product, a few days of calm would be a welcome change. Last week’s economic data did little to solve the debate between the greater of two concerns: growth or inflation. The core PCE index, the Fed’s favored inflationary gauge, fell to 2.1% in the second quarter from 2.3% in the first. Still, the yearly clip remains elevated to the Fed’s comfort zone of 1-2%, which, if you look at against a historical backdrop seems like a nice place to visit rather than a place where we have spent a whole lot of time. The first chart shows the historical readings for both core rates (CPI and PCE) for the last 30+ years along with the 1-2% range of relaxation. Far be it from me to second-guess the members of the Fed for feeling that 1-2% is the appropriate level, but it does seem arbitrarily low to what we have experienced during different growth cycles over the last three decades. What I also get out of this chart is how absurd it is to talk about hiking rates when the marginal amounts that the rates exceed this targeted zone are minimal by comparison. Having the belief that the Fed must do what it can to counteract inflation is not the part I find ridiculous, rather, it is talking about this risk in the midst of one of the biggest deleveraging cycles in history.
It is only my humble opinion but I want to say it one more time for the cheap seats; what makes this credit crisis so different is not that the economy is facing headwinds, rather that this may be the first time that the average consumer is getting a margin call that they cannot refinance their way out of. The proliferation of debt derivatives, the broader base of investors/lenders/borrowers, and the shear amount of outstanding leverage that the aforementioned factors created leads me to believe that we will be dealing with this for several years rather than several more quarters. Here’s a question for those out there who are saying that the worst is behind us: if the credit fog is really starting to lift, why did the Fed just expand and extend the liquidity facilities it put in place earlier this year? The Fed announced last week that it was going to use a portion of the $150 billion Treasury Auction Facility or TAF for 3-month auctions. They also announced the extension of the Treasury Securities Lending Facility (TSLF) and the Primary Discount Credit Facility (PDCF) till the end of January. The New York Fed is going to start auctioning options on access to the TSLF to provide better dynamic positioning in front of month-end/quarter-end periods of duress. The Fed also increased its swap line with its overseas counterparts to help facilitate more inter-bank lending, something that is still far away from what would be considered a normal level. As I have said in the past the Bernanke-led Fed really did think outside the box and come up with some innovative ways to avoid using their most well-known blunt instrument, the target rate. But they wouldn’t be doing it if they truly saw improvements in the overall credit market. Last week we saw a form of capitulation as Merrill came out and hit the bid on some Level III assets, taking the real pain that so many others have only written down to this point. That is what has to happen on a much broader basis for there to be a true turnaround in the credit markets. My biggest fear now is that the subprime mess will seem like a blip on the radar if deteriorating credit starts to spread to Alt-A, non-prime, and (gasp) prime borrowers. I keep going back to JP Morgan’s conference call and the one thing that keeps ringing in my head is when Jamie Dimon said that losses on prime mortgages could triple over the next year. TRIPLE!! Prime borrowers face the same high loan-to value problems as their less documented counterparts in the same troubled states but up until now some have had longer option periods on their ARMS. For all the pain that subprime inflicted most understood that it would soon subside since it is a small percentage of the overall pie. But when you start talking about well-documented prime borrowers running into problems it is hard to believe that this is over, especially given the ongoing contraction in credit creation. It is not getting any easier to refinance into better terms.
The Government is certainly trying to pass everything it can with the name “Housing” and “Help” in the title (after all it’s an election year) to stem the tide from rising any further and to a broader base. The Housing and Economic Reform Act of 2008, passed last week, should help shore up the GSEs (hopefully so they go out and purchase back more conforming loans and get the liquidity ball rolling again) and insert the Federal Housing Authority directly in the thick of things to aide in the housing recovery…did I mention that the National Association of Realtors homebuyer affordability index dropped again last month? Median prices and rising, yes rising financing rates continue to pressure home affordability, all while supply stays highly elevated. Buying existing debt will definitely help but when will the housing market find a clearing point? The losses on the collateral is what is driving the need to de-leverage, thereby tightening credit and inducing further losses as the trouble spreads to higher tier sectors of collateral. If a bigger percentage of losses start coming from prime and Alt-A paper the illiquidity in the debt markets will make the current glacial pace of clearing look like a cake walk in comparison.
This week brings fresh supply in Treasuries in the back end of the curve (10s and 30s). This along with the extension/expansion of the Fed’s facilities should compress the swaps curve, which remains inverted. The elevation in front-end swap spreads as well as those between LIBOR-OIS and short-term bills to LIBOR (TED spread) show that the market continues to position for ongoing stress in short-term funding needs. Other economic releases of importance this week include personal income and spending (which contains the monthly and year-over-year PCE data), pending home sales, Consumer Credit, ISM Services Index, and Productivity/Unit Labor Costs. The Fed will remain at 2% but the street will be looking for the dissenters. Did they grow in rank or has their inflationary discontent softened in the face of seven straight months of negative payroll data, more write-downs, rising delinquencies, and a softening in crude? Chances are they will only soften to the point of reinforcing the “sooner rather than later” mantra, yet not forcing the issue of exactly when “sooner” might be. -BDT
The author of this material is a Proprietary Trader/Desk Strategist in the Fixed Income Division of Raymond James & Associates, not a Research Analyst. Any opinions expressed may differ from opinions expressed by other divisions of Raymond James including our Equity Research Department and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but Raymond James does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitutes a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities, and/or derivatives that Raymond James may have positions, long or short, held proprietarily. Raymond James may have also performed investment-banking services for the issuers of such securities. Investors should discuss the risks inherent in bond with their Raymond James Financial advisor. Risks include, but are not limited to, changes in interest rates, credit quality, volatility, and duration. Past performance is no assurance of future performance
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