Tight supply, Fed support seen in Q4, analysts say; value in flatteners, longer-term paper

By Kenneth Lim

Boston, Sept. 30 - Agency spreads should continue to find support in the final quarter of 2009 from the extended federal purchasing program and low bullet issuance, analysts said as September drew to a close.

Short-end spreads remain too rich, while value can be found in flattener trades and farther out on the yield curve, the analysts said.

As the end of the third quarter approached, the Federal Reserve answered one of the market's biggest unknowns with the announcement that it would extend its $200 billion outright agency coupon purchasing program by three months to the end of the first quarter of 2010, and that it would taper the buying.

The move should "improve technicals further and support valuations," wrote JPMorgan analyst Meera Chandan in a note.

"It will also likely be supportive of lower volatility in agency spreads, particularly in the months going into year-end, since it will ensure availability of balance sheet to this sector in the event that investor risk appetite starts to wane once again (admittedly, not our base case scenario)," she wrote.

Although the extension will allow the Fed, which has already bought about $130 billion of agency debt, to reach closer to its $200 billion target, the central bank may still have difficulty getting there, Chandan added. One hint is in a slight change in language from the Fed, which had previously said it would buy "up to" $1.25 trillion of agency mortgage-backed securities and $200 billion of agency debt. But the latest statement from the Fed changed the MBS language to buying "a total of" $1.25 trillion while keeping the "up to" usage for agency debt.

Lower supply

While the Fed provides demand, the supply side of the picture should see "extremely low bullet issuance" prevail through the end of the year, wrote RBS Securities Inc. agency strategist Margarent Kerins in a note.

"Agency large deal issuance has been very low with only $1 billion reopenings from Fannie Mae and Freddie Mac on the last four issue dates and one [Federal Home Loan Banks] $3 billion issue," she wrote. "September large deal issuance totaled $6 billion, which is the lowest monthly level of the year and much less than the monthly average of $15 billion year to date and $12 billion over the past 3 years."

Heading into 2010, Fannie Mae and Freddie Mac will be expected to issue at a minimum because of their need to reduce their retained portfolios by 10%, while FHLB also needs to issue only about $3 billion per month in the new year, Kerins forecast.

"The shorter-term nature of the advance book supports this debt mix, which could cheapen the front-end of the yield curve," she wrote.

One unknown, however, exists in the funding of modified loans that were purchased out of trust, which could affect the amount that Fannie Mae and Freddie Mac issue. This issue will likely be addressed when the White House reveals its plans for the mortgage agencies in February 2010, Kerins said.

Short richness

The third quarter ended with spreads at the short end of the curve extremely tight, and both analysts saw little value in that sector.

"The short end of the agency curve remains rich to bills as issuance has been low," Kerins wrote. "While the upside is non-existent, cheapening seems unlikely as supply is expected to remain limited into year-end... Although the 2yr sector continues to offer the best roll down the curve and breakevens, it's hard to get excited about 10 bps."

Chanda recommended going underweight on two-years versus Treasuries.

"Even though the holding period of this trade is now over our self-imposed 3-month limit, 2-year valuations still appear too rich relative to fair value and as a result we stay underweight the sector," Chanda wrote. "We continue to express this view using the April 2011 issues since these are still the on-the-run bonds in this sector."

Flatteners, step-ups in vogue

Chanda also sees a good trade in betting on a flattening two-year, five-year curve versus Treasuries.

"We expect the curve to flatten as investors extend further out the curve to pick up yield, and we recommend positioning for a flatter 2s/5s spread curve," she wrote.

A range-bound rate environment should also be positive for callable performance, and Chanda recommends being overweight on three-year, non-callable six-month, paper compared to partial-duration-matched Treasuries.

Kerins noted that step-up callables have been very popular with investors.

"We are seeing strong demand for step-ups and three-year finals with both 6 month and 1 year locks as investors take advantage of the steepness of the curve and forward rates," she wrote. "In addition, traditional CMO buyers have been looking at callables as an alternative to the rich asset class."

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