Agency spreads mostly flat, slightly wider in three-year sector; Fed eyes short-end paper

By Kenneth Lim

Boston, Oct. 15 - Agency spreads in the three-year sector came under slight pressure on Thursday amid greater supply, while callable issuance remained brisk.

The Federal Reserve Bank of New York also announced that it will buy one- to two-year agency paper on Friday as part of its outright coupon purchase program.

Bullet spreads were mostly flat across the yield curve on Thursday, although the three-year sector widened slightly, said Michael S. Effron, head of U.S. government agency at Jefferies & Co.

"Three-year spreads were under a little bit of pressure," he said. "Other than that it was a pretty average day. Swaps are out a little bit at the front end, probably pushed spreads out a bit at the front end. Two-year and three-year swaps are out a bit."

The weakness in the three-year sector was on a combination of cyclical factors and additional supply.

It's "just rotation out of the sector," Effron said. "[Federal Home Loan Banks] priced a lot of supply in that sector, which pushed spreads out...it's just piling on."

The government-sponsored enterprises space also suffered from competition from $4 billion of new supply by U.S. Central Credit Union, which is backed by the federal Temporary Liquidity Guarantee Program. The three-part deal of two-year fixed notes, three-year fixed notes and a two-year floaters drew good response, with the fixed-rate notes tightening by about 12 to 13 bps early Thursday, Effron said.

"I think accounts are buying those," he said. "It's a way to pick up a little bit of spread."

Callable surge

Callable issuance volume was robust on Thursday, one trader said.

"Callable issuance was very strong," the trader said. "Callable spreads are off 1 to 1.5 bps across the board, but issuance was pretty significant. A couple of big global-sized deals did get done."

Effron noted that just over $4.1 billion of new callables from 37 deals were added on Thursday, Effron said.

"Home Loans had a tremendous amount of issues," he said. "They've been issuing very short lockout bonds lately. It's an alternative funding source."

The callable issuance is less a reflection of the agencies' funding needs than the current rate environment, Effron said.

"What we're seeing right now with the issuance for at least Home Loans and [Federal Farm Credit Bank], and to some degree the other guys, it's those guys calling bonds," he said. "It's roll-over funding needs, not really other funding needs. It's absolute low rates, tight spreads for issuance and the ability to call bonds and reissue at lower rates."

Fed to buy at short end

The Fed announced that it will buy agency paper due 2010 and 2011 on Friday as part of its outright coupon purchase program.

The announcement's impact on short-end paper was marginal on Thursday, one agency trader said.

"The impact isn't very big, especially in two-years and shorter, which are already as tight as you can go. There's really not much room for them to move at this time," the trader said.

If the Fed buys a very large amount of agency paper on Friday, that might pull spreads slightly tighter, but the trader did not think that would happen.

"The Fed has said they're going to be buying less and less until the buybacks end after the first quarter [of 2010], so if anything I would expect the amount that they buy every week, both the dollar amount and the percentage [of securities offered] to be decreasing," the trader said.

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