Agency spreads firmer at long end as Fannie Mae's new $3.5 billion bullet issue performs well

By Kenneth Lim

Boston, Oct. 23 - Agency spreads firmed at the longer end of the yield curve on Friday amid strong demand for Fannie Mae's new five-year bullets.

The Fannie Mae deal priced close to talk and ended the day slightly tighter.

"It was busier in the morning, when the highlight of the day was definitely the Fannie Mae five-years," said Michael Skinner, an agency trader at Wall Street Access. "It was very well received."

In terms of prices, "both bonds and stocks lost ground today," Skinner added.

Bullet spreads at the shorter end of the curve were slightly weaker, but further out in five-year and beyond territory, spreads improved by about 1 basis point, he said.

"The Fannie Mae deal...helped to bring spreads in in the belly of the curve and further out," Skinner said.

Volumes remained thin, consistent with a lethargic week for agencies.

"It felt like a Friday in the summer, shall we say," Skinner said.

Over the week, spreads did better in the back end of the curve. Two-year spreads are about 2 bps wider on the week, while three-years are about 3 bps wider. Out in 10-years, spreads are about 4 bps tighter, he added.

"A lot of people have started entering the flatteners," Skinner said. "The easy money period isn't going to last forever...so people are finding more value in the long end of the curve."

The next couple of weeks could see an increase in supply in Treasuries, which could affect rates, he added.

"There's a lot of supply coming in next week," he said. "Looking at the 10s, they should hold around the 3.50% level, so the next couple of weeks should be interesting with the supply."

Skinner expects spreads to "do OK" for the rest of the year.

Fannie Mae new deal tightens

Fannie Mae priced $3.5 billion of 2.625% Benchmark Notes due Nov. 20, 2014 on Friday at 99.474 to yield 2.737%.

The yield equated to a spread of 33 bps over Treasuries, at the tight end of price talk for a spread of 33 to 35 bps.

Barclays Capital Inc., Deutsche Bank Securities Inc. and J.P. Morgan & Co. were the lead managers.

The notes are non-callable.

The notes "traded pretty well out of the break, and it's going to go out about 1.5 bps better," Skinner said.

"We saw some good demand for it," he said.

Domestic investors bought the bulk of the offering, with 64.4% going to U.S. buyers while Asian investors bought 13.4% and Europe took 4.9%, according to data from Fannie Mae.

Fund managers were the largest group of investors, buying 53.4%, followed by central banks with 29.5% and commercial banks with 6.9%.

Callables find fans

Callable issuance continued to be active on Friday.

"I think there's more value in the callable side right now," Skinner said.

Barclays Capital agency analysts Rajiv Setia, Piyush Goyal and James Ma also made a case for step-ups in a research note.

The analysts pointed out that "stronger-than-expected quarterly earnings from a wide range of companies are continuing to build investor conviction on the sustainability and breadth of the economic recovery."

"Hawkish Fed rhetoric has also picked up, and investors are growing increasingly focused on the prospect for higher front-end rates next year," they wrote.

Those conditions raise the attractiveness of high-quality, shorter-dated floating-rate products. Indeed, agency, foreign government-guaranteed and Temporary Liquidity Guarantee Program floaters are now trading at Libor versus a year-ago spread of 85 bps over Libor.

But step-up callables offer better value than the floaters, the analysts said.

"With three-month Libor setting at 28 bps and a Fed rate hike unlikely before late 2010, near-term carry prospects on floaters are dismal," they wrote. "In our view, step-up callable offer a far better alternative for defensive investors."

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