Agency spreads contract as Fannie Mae prices $1 billion reopening; value seen in front end

By Kenneth Lim

Boston, Aug. 26 - Agency spreads were slightly tighter on Tuesday after Fannie Mae received good interest in its $1 billion reopening of three-year Benchmark Notes.

"Swaps came in about 1 to 2 basis points; agencies were kind of tracking that in," said Scott Graham, head of U.S. government agency trading at RBS Securities Inc.

Bullet spreads shifted inward slightly across the yield curve, but traders cautioned that volumes were so light that the market was as good as unchanged on the day.

"Spreads were probably marginally tighter on the day," one agency trader said. "There's no real flow. It's so slow I can't even really say if [callables] are better or worse.

Fannie Mae reopens three-years

Fannie Mae on Wednesday priced a $1 billion reopening of its 1.75% notes due August 2012 at a yield of 1.823% through an auction.

Fannie Mae now has $4 billion of the 1.75% notes outstanding.

Graham said the auction was not a major market mover.

"Fannie Mae had a reopening. It kind of came and went," he said. "I think we're in the middle of the summer doldrums."

An agency trader said the auction went "OK," noting that the notes came in slightly by the end of the day.

"It was about 30 bps over when it priced, it ended about 1 bps tighter," the trader said. "But it was really light trading."

The deal was not a big surprise for the market, the trader said.

"The market was kind of looking for something in the short end of the curve, so they didn't disappoint," the trader said. "I think some people were expecting them to pass or do a two-year; so, maybe there was a bit of widening in the three years when they announced the reopening, but overall it's still only a very small deal and not too far from what people were expecting."

Front end believer

The short end of the yield curve is also where Thomas D.D. Graff, managing director and assistant portfolio manager at Cavanaugh Capital Management, currently sees the most utility for a rich market, he told Prospect News.

"Most of my agency portfolio is in the one- to three-year part of the curve," Graff said. "What I'm using agencies for is more of a liquidity placeholder, and you may as well buy the shorter agencies if that's what you're looking for."

Graff noted that spreads have widened slightly in the past two weeks, but he expects the market to hover around a range as the Federal Reserve's open-market purchasing program heads to a close at the end of the year and the government decides how to reorganize Fannie Mae and Freddie Mac.

The ultimate fate of Fannie Mae and Freddie Mac is unlikely to change the fundamental backing of their securities, he reasoned. And while Graff acknowledged that there is quite a bit of uncertainty about how the Fed will end its purchasing program, he sees signs that they will be "responsible."

"The responsible way for them to end it would be to slowly curtail the purchases," he said. "I think that's where they were coming from with what they said about the Treasury program in the most recent meeting."

Graff is underweight five-year agencies on expectations of a flattening yield curve and has not followed the crowd in buying step-up callable structures.

"I cannot remember a time in my career where issuance in step-up bonds is so numerous," he said. "Investors are so desperate for yield."

Straight callable notes can offer better upfront coupons, and the promise of a better future coupon in the step-up is not as nice as it sounds, he said. If current conditions persist, investors may not get the step-up coupon. If interest rates rise, the notes may not be called and the step-up interest may not be attractive. And if rates fall, investors will not benefit from price increases.

"It's all risk and very little upside," he said.

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