Fixed Income Market Commentary

Transcription

1 First Principles Capital Management August 2011 Fixed Income Market Commentary Liquid rates markets Treasuries staged an impressive rally in August The primary drivers of the rally were short-covering after Standard & Poors announced the downgrade of the United States long-term credit rating to AA+ from AAA on August 5, the Fed s August 9 announcement that it expects to keep the Fed Funds rate low until at least mid-2013, and continued concerns about economic growth and European sovereign debt. For the month, Treasury yields fell 41 basis points, LIBOR swap yields decreased by 38 basis points, and TIPS real yields rallied 1 basis point. Forward swap rates at bottom of historical trendline Forward interest rates have declined significantly since July, as credit fears of a U.S. Treasury downgrade subsided and growth concerns increased. The all-out duration grab that commenced at the end of July pushed even the normally sticky forward rates down to levels last seen during the buying frenzy right before last year s QE2 announcement. For example, the 5-year swap rate, 7-years forward closed at a local low of 3.724% on August 31, 2010 then dipped to 3.66 on August 19 of this year. A review of the historical levels for this 5-year forward yield reveals that current levels correspond closely to the bottom of the 20-year trendline (see Graph 1). Graph 1: Historical levels for 5-year swap rate, 7-years forward ( USFS075 ) USFS075 Trendline While we believe it is likely that this forward rate will not significantly violate the trendline and will eventually commence movement upward, we think it will pay to be patient before positioning for this trade. A number of forces will attempt to exert downward pressure on forward rates: stock market volatility, an unresolved European debt crisis, lackluster economic growth, a Fed on hold for two years, and the potential Operation Twist from the Fed in which they may sell shortmaturity Treasuries to purchase long-maturity Treasuries. Calls for Operation Twist are gaining momentum among fixedincome participants, and as evidenced by the recent flattening of the yield curve, the market has already started pricing it in. Graph 2 below illustrates that the spread between 2-year and 30- year swap rates has narrowed over 60 basis points in the last two months. Graph 2: 2-year and 30-year swap rate differential (in basis points): /30/2011 7/31/2011 8/31/2011 We anticipate the price action this time around to be similar to that of last year leading up to QE2. In 2010, rates products rallied significantly into the announcement of QE2 by the Fed. This time, the market may experience further bull flattening until Operation Twist is nearly fully priced into the market. Liquid rates market outlook Last year, in the set-up to QE2, the 5-year forward yield (Graph 1) dipped to a low of 3.724%. In anticipation of Operation Twist, it closed at 3.66 on August 19, 2011, below 2010 s low. Are economic conditions worse now than in 2010, warranting lower forward rates? Looking at the SPX index as a proxy for corporate health, we see that SPX hit a low of 1, on July 2, 2010 prior to QE2. August 8 marked this year s low for SPX with an index close of 1, So, the equity market is currently stronger than it was last year before the Fed action. Page 1

2 If we consider GDP, however, we see the latest estimate for 2Q11 GDP was 1.0, significantly lower than the 2Q10 GDP of 3.8%. While financial conditions for corporations have improved from last year, economic output has suffered set-backs. This would seemingly justify recent rate action. While the trendline would suggest forward rates have troughed and may experience a rebound, we think the rebound may be short-lived given the Fed s determination to keep short-term interest rates anchored; roll-down and carry will simply become too painful for market short positions to persist. We believe rates may oscillate around the trendline for a while to shake out the short-positions before a true meaningful sell-off will occur. 4% MTD change (bps) % % 1.16% -0.9 Treasury Yields 8/31/11, Barclays Capital TIPS/Breakeven Yields 8/31/ % -0.8 Yields % MTD Real Yields change (bps) BE %, Barclays Capital Securitized markets YTW Modified Duration Spread Duration Auto ABS Credit Card ABS AGY Hybrid Arm 1.64% AGY Fixed Rate MBS 3.06% CMBS 4.09% Source: Barclays Capital In August 2011, agency fixed-rate MBS rallied, outperforming other liquid rates markets on a duration adjusted basis. For the month, the FNMA 30-year fixed-rate current-coupon rate decreased 45 basis points. In comparison, for the month, Treasury yields rallied 41 basis points and LIBOR swap rates declined 38 basis points. Current coupon MBS cheap on LOAS basis The LIBOR option-adjusted spread ( LOAS ) for Fannie Mae, current-coupon, 30-year fixed-rate MBS ( FNMA CC ) has been on a widening trend since the Fed s MBS purchase program ended at the close of the first quarter of 2010 (see Graph 3). FNMA CC LOAS hit a low of roughly -20 basis points during the peak of the Fed s MBS purchase program in the beginning of 2010 and has recently widened out to around 65 basis points. Mortgage spreads are now at the widest level since 1996, except during the Lehman crisis. Graph 3: FNCL current coupon LOAS (in basis points) (20.00) (40.00) Page 2

3 While a number of factors are contributing to the widening of MBS LOAS, chief among them is the sudden disappearance of a large sponsor, namely the Fed. The Department of Treasury s March 21 announcement of their intention to start liquidating their then $142 billion MBS portfolio also added to pressure on mortgage spreads. In addition, Fannie Mae and Freddie Mac have been steadily reducing the size of their investment portfolios, further removing demand from the MBS market. Act, then REITs will need to significantly deleverage their positions. In this event, the mortgage market would likely cheapen. However, we are in the early stages of this discussion, and it is far from certain what, if anything, will transpire. We believe it may make sense to start scaling into some hedged MBS positions. If MBS continue to cheapen on the back of a negative outcome for REITs, then we would add to the position. Another important factor contributing to the widening of mortgage OAS is the decrease in option costs as a result of the Fed s intention to keep interest rates low until at least mid Turning our attention to the at-the-money-forward ( ATMF ) European swaption daily basis point volatility on a 1-year option for the 5-year swap rate, we see a dramatic drop in the last couple of months (see Graph 4). Graph 4: 1-year into 5-year ATMF swaption daily basis point volatility 8.50 Municipal bonds AAA GO Muni Yields 8/31/11 5% 4% 3.97% % % 0.27% MTD change (bps) While mortgage option costs have declined, zero-volatility yield spreads between MBS and swaps have remained relatively steady, causing LOAS on MBS to widen. Securitized markets outlook Current coupon MBS LOAS are at some of the widest levels of the last 15 years. In our opinion, they are attractive for accounts that can hedge the interest rate and volatility risk of MBS and take advantage of the recent steep decline in option costs. The SEC is currently seeking comments from market participants to gauge whether REITs should continue to enjoy exemption from the 1940 Investment Act, in which allowed leverage is much lower than that of REITs currently. If the SEC determines that REITs should abide by the guidelines of the 1940 Investment Following a lackluster July, tax-exempt municipal bonds performed in-line with other liquid rates sectors in August For the month, the Bloomberg AAA G.O. yield curve dipped 35 basis points, while Treasury yields rallied 41 basis points, and the LIBOR swap yield curve dropped 38 basis points. U.S. sovereign rating downgrades impact on municipal bond market On August 5, S&P downgraded the U.S. sovereign debt rating to AA+ from AAA. Following this action, S&P lowered the ratings on municipal housing bonds guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac to AA+ from AAA. S&P lowered the ratings on pre-refunded bonds to AA+ from AAA. S&P affirmed the ratings on 239 classes from 178 ABS transactions backed by FFELP student loans and removed them from negative watch. The rating affirmations and removals from Page 3

4 negative watch include 26 classes of FFELP AAA rated senior bonds from 22 transactions, with the remaining affirmations affecting senior bonds rated no higher than AA+ and mezzanine and subordinate bonds rated no higher than AA. The ratings on 118 Classes from 63 FFELP student loan transactions, rated below the ratings on the U.S., remain on negative watch due to performance or counterparty-related issues. S&P also left ratings on 1,035 classes from 295 FFELP student loan transactions (rated AAA and AA+) on negative watch due to U.S. sovereign exposure and/or counterparty-related issues. S&P issued a report, however, stating that state and local government ratings are not directly constrained by that of the U.S. sovereign. Pursuant to S&P s criteria, the fiscal autonomy, political independence, and generally strong credit cultures of U.S. state and local governments can support ratings above that of the U.S. sovereign s AA+ rating. S&P also indicated it will not downgrade state and local government credits until details of the federal deficit reduction plan are known, which will likely be near the end of Central Falls filed bankruptcy On August 1, 2011, Central Falls in Rhode Island filed for Chapter 9 bankruptcy. This decision came after unions and retirees failed to agree to reductions in benefits of up to 5, even after they were warned they could risk losing everything in bankruptcy. Central Falls, the poorest city in Rhode Island, has a population of approximately 19,000 and per capita income at a level that is roughly half of the rest of Rhode Island. According to Moody s, the city has $20.8 million outstanding debt. The city also has $80 million in unfunded pension and benefits obligations. Mr. Robert Flanders, a judge appointed to oversee the city s finances, said he planned to reduce pension benefits beginning in late August. He has asked the federal court to immediately reject collective bargaining agreements. At the same time, city workers will face layoffs. Central Falls is the 5th municipal entity to file for bankruptcy this year. Earlier this year, Rhode Island passed a new bondholder-friendly state law that established priority for general obligation bond and note payments over other obligations in the event of a government entity filing bankruptcy. Under the new law, cities, towns and districts are required to dedicate property taxes and other general revenues to pay debt service before any other claims or payments. Since Central Falls is the first municipal bankruptcy in Rhode Island, it is uncertain how municipal bondholders will fare under the new law. The city plans to pay bond investors the entire $635,000 debt service due in October. Jefferson County hired bankruptcy lawyer but has not filed bankruptcy On July 26, Jefferson County, Alabama, voted to hire bankruptcy lawyer Kenneth Klee and his Los Angeles firm (which represented Orange County in California when Orange County filed for bankruptcy in 1994). However, Jefferson County has not yet filed for Chapter 9 bankruptcy. Since 2008, Jefferson County, home to Birmingham, has been in financial distress over its $3.14 billion sewer bond refinancing. On August 12, the county rejected a proposed creditor settlement offer that would have reduced the debt to $2.33 billion. Instead, the county extended talks with creditors until September 16. If Jefferson County files bankruptcy, it would be one of the largest municipal bankruptcies in U.S. history. Major positive rating actions Charleston County (SC) general obligation debt was upgraded to AAA from AA+ by Fitch, due to the county s strong financial management and increasing diversification of a stable local economy. The county has $575 million of outstanding G.O. debt. Major negative rating actions State of New Jersey was downgraded to AA- from AA by Fitch, due to mounting budgetary pressure from pension and employee benefit deficits. Fitch s rating is now in line with Moody s Aa3 and S&P s AA-. Puerto Rico general obligation debt was downgraded to Baa1 from A3 by Moody s with a negative outlook. The downgrade reflects the commonwealth s continued financial deterioration of the severely underfunded retirement systems, continued weak economic trend, and weak finances, with a historical trend of funding gaps. City of North Las Vegas (NV) $445 million general obligation debt was downgraded to A2 from A1 by Moody s, due to weak financial performance in recent years and tax base deterioration. Fitch downgraded 98 of its 250 ratings on tobacco settlement bonds. Some were downgraded below investment grade. All of the downgrades are either capital appreciation bonds or turboterm bonds. No serial bonds were downgraded. Tobacco settlement bonds total approximately $54 billion. Municipal bond market outlook In the face of various credit and geopolitical concerns this year, the municipal bond market has ebbed and flowed relative to other liquid rate sectors; however, municipal bonds have performed well on a beta-adjusted basis versus Treasuries and LIBOR swaps year-to-date. For example, as of August month-end, the 10-year Treasury rallied 152 basis points from its cheapest level of the year. Meanwhile, the Bloomberg AAA municipal index rallied 126 basis points from its peak yield of this year. Given the usual duration hedge ratio of around 6 for munis, municipal bonds performed very well on a hedged basis versus Treasuries for the year. Page 4

5 Anecdotally, municipal bond managers have been quiet recently given the low level of yields in general, concerns over potential selling of taxable munis by European banks to reduce leverage, lack of buying by property and casualty insurance companies to preserve cash for hurricane-related claims, and the anticipation of increased supply in the last quarter of the year. But, as is the case with liquid rates sectors, we anticipate low rates to persist for a while which may cause many investment managers to throw in the towel and align their positions more closely with their respective indices. This could cause further outperformance of munis versus Treasuries and LIBOR swaps on a beta-adjusted basis Total returns for fixed income sectors YTD % 4.99% 6.98% 6.18% Agency Securitized Treasury Muni (AAA) Corporate Source: Barclays Capital David Ho, Managing Director dho@fpcmllc.com Rongfeng Becky Li, Vice-President, CFA bli@fpcmllc.com 2011 First Principles Capital Management, LLC 140 Broadway 18th Floor New York, New York Page Tel Fax