Agency spreads uneven amid supply pressure; Freddie Mac sells $3 billion three-year notes

By Kenneth Lim

Boston, Aug. 19 - Agency spreads closed mixed on Thursday as Freddie Mac supply put pressure on the front end of the yield curve.

Bullet spreads widened in the two- and three-year sectors, although the widening in the shorter paper caught the attention of some investors, an agency trader said.

"The perception in two-year land is spreads are cheap, although they're single-digit basis points versus swaps," the trader said. "People have been looking at this stuff at flat to minus 5 bps versus swaps."

Spreads in the 10-year and longer part of the curve actually narrowed because of the low yields in the front end that have led to some investors chasing yield in longer maturities.

"Spreads tightened a little bit in 10s and longer," the trader said. "[There's] better buying in concert with the flattening trend of the curve. It doesn't signify any agency value per se, just more yield. Accounts have been forced further and further out the curve."

Callable issuance remained active, fueled by the relentless stream of older paper getting called because of the low interest rate environment. The trader, who said his screens showed an above-average "four pages of issues getting called," noted that not all the money leaving the market is getting reinvested because callable spreads are extremely rich at the moment.

"A certain amount has to remain in agencies, but I had an account ... [that] had some short agencies shifted into short corporates," the trader said. "There are certain sectors where you can almost buy bullets as cheap as call...you're better off not paying for that optionality."

Freddie Mac sells three-years

Freddie Mac's new 0.875% Reference Notes due October 2013 closed flat at a spread of 22.5 bps over Treasuries.

"I get a sense the Freddie Mac deal was not an over the top success," the trader said. "I know it was well subscribed, but it's just the action of the sector, which widened 1 bp during the marketing phase."

Freddie Mac priced $3 billion of the notes on Thursday at a spread of 22.5 bps. The notes were sold at 99.661 to yield 0.983%. Price talk was at a spread of 22 bps.

The size of the deal was indicated at $3 billion to $4 billion during marketing.

Barclays Capital Inc., Deutsche Bank Securities Inc. and UBS Investment Bank were the lead managers.

The widening ahead of pricing suggested that investors were resisting the currently rich valuations in the three-year sector, while the deal's concession of roughly 1 bp to current issues was aggressive. Of course, that richness was probably also why Freddie Mac chose to issue in that sector.

"It was offered at the pricing level at the close, which surprised me because I thought it was fairly valued," the trader said. "People might just be running up against a yield wall here."

The deal may have also dimmed slightly in comparison with Fannie Mae's three-year offering two weeks ago.

"The Fannie Mae deal came at higher yields and a bigger concession to the existing sector," the trader said.

Positive tone

Despite the market's lack of a clear direction, the trader saw a positive bias in the market.

"There are a lot more buyers than sellers," the trader said.

Disappointing jobless claims numbers and a drop in the Federal Reserve Bank of Philadelphia's business activity index on Thursday did not spook agency investors that much because spreads have lost some importance in their minds, especially when they are so tight at the front of the curve. Instead, money is looking at absolute yields.

"We're pretty much holding a rate product now," the trader said. "The agency curve is basically sub 1% out to the end of 2013. You have to go that far out to get 1% in bullets."

Accounts that had been reluctant to take on additional risk just for yield a few months back are under pressure to improve their returns as interest rates continue to retreat.

"Everyone's been sitting on the sidelines waiting, and watching their returns diminish," the trader said. "If you're a portfolio manager, you're watching your competitors get better returns. At some point people get sucked in, then you get capitulation."

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