Agency bullet spreads widen as money flees supra-sovereigns; Fed buys paper at front end

By Kenneth Lim

Boston, Feb. 4 - Agency bullet spreads remained soft on Thursday despite a flight of money from lower-quality supranationals and sovereigns, but callables traded tighter on falling volatility.

The Federal Reserve Bank of New York bought $1.099 billion of two- to four-year agency notes, but the action was largely a non-event in a market that is already looking beyond the weekly purchases.

Bullet spreads were slightly wider on Thursday, an agency trader said.

"For the most part we were a little bit softer," the trader said. "There's a lot of stuff going on in other markets. A lot of action has been in the front end with the discount note window...Agency notes are a little bit wider in line with swaps. I see some rate selling at these levels."

Callable spreads did better, tightening as volatility continues to keep "getting crushed," the trader said. Callables currently look rich, but investors are still hungry for the additional yield that they provide.

"Some people are simply buying callables to get the yield, but from a valuation standpoint, the options that you're selling, it seems a little bit pricy," the trader said.

Michael J. Gladden, vice president of institutional sales at Mischler Financial Group, said callable spreads were 5 to 6 basis points tighter on Thursday.

Trading volumes reflected the disparity in the market, with bullets rather quiet while callables had an active session.

"Most of the action was in the callable one-year area," Gladden said.

Flight to quality

The credit markets saw money leave lower-grade supranationals and sovereigns for safe assets amid concerns about the credit strength of Greece, Portugal and Spain.

"There was some pretty good demand due to the sovereign debt issue problems," Gladden said.

The market's reaction on Thursday helped to keep spreads from widening further, but Gladden expects the flight-to-quality effect to wear off in the days ahead.

"It was a knee-jerk reaction," he said. "It should come down tomorrow when we have the employment numbers...We'll widen back out 4 to 6 bps today or tomorrow if we get the five-year closer to 2.4%."

The other trader added that most of the concern is focused on lower-grade supra-sovereigns, but the higher quality paper in that market continues to attract funds from investors who are getting out of the lower-quality supra-sovereigns as well as from investors seeking better yields than agencies. So while agencies are "participating in the flight to quality," in terms of spreads they continue to see widening.

"Right now you're still seeing flows out of agencies and into supra-sovereigns to pick up yield," the trader said. "I think guys are still doing that in the higher credit stuff."

Fed buys near front end

The Fed bought $1.099 billion of agency notes due February 2012 to January 2014 on Thursday as part of its weekly purchase program.

The central bank accepted 30% of the $3.664 billion of notes offered.

The operation did not appear to do much for spreads, Gladden said.

"I didn't see that this morning," he said.

The other trader said the approaching end of the Fed program is a key reason for the recent widening in agency spreads. The Fed has now bought about $165 billion of agency notes through the $175 billion program, which will end by March 31.

"We've been supported by the ongoing buyback program, and we're now within $10 billion of the end of it and they're just going to dribble it out over the next month," the trader said. "Just like in mortgages, the concern is when the Fed goes away, who's going to buy, so there's some cheapening related to that."

There is also nothing on the horizon that appears to be able to tighten the market once the Fed is gone, the trader added. The House Financial Services Committee said Thursday that it will have a hearing on March 2 to consider the future of Fannie Mae and Freddie Mac, which could give the market some direction, but realistically the market is not expecting any major changes for years, the trader said. And until then, front-end agencies are trading on a liquidity spread.

"What you're left with is kind of in-between credit," the trader said. "The spread is the liquidity difference rather than the credit difference."

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