Fixed Income Market Commentary

Transcription

1 First Principles Capital Management June 2012 Fixed Income Market Commentary Liquid rates markets On June 20 the FOMC announced another round of operation twist in lieu of the more widely expected quantitative easing III. The rates market responded to the announcement with a moderate sell off. For the month, Treasury yields sold off 8 basis points on average, LIBOR swap rates increased 2 basis points, and TIPS real yields sold off 12 basis points. contemplate a viable alternative to LIBOR. The issue of credibility is the tougher of the two questions, as there are many legal, regulatory, and market implications associated with any fundamental change. In fact, identifying a viable alternative to LIBOR swaps is relatively easy, with the Overnight Index Swaps ( OIS ) being a good candidate, in our view. Treasury Yields 6/29/ % 1.65% Y 5y 10Y 30Y An OIS is a fixed versus floating interest rate swap whose floating leg is the geometric average of the daily effective federal funds rate ( Rate ), which is the interest rate at which depository institutions lend balances to each other overnight. The target rate for trading in the Federal Funds market is established by the Federal Open Market Committee ( FOMC ); however, the Rate is a volume-weighted average of rates on trades arranged by major brokers. The Rate is calculated by the Federal Reserve Bank of New York using data provided by the brokers, is subject to revision, and is published daily on the Federal Reserve Bank of New York website. MTD change (bps) % TIPS/Breakeven Yields 6/29/ % -1.0 Yields -0.49% 2.14% % MTD Real Yields change (bps) Overnight Index Swap ( OIS ) viable alternative to LIBOR swap The recent LIBOR setting scandal has called LIBOR s credibility as a benchmark in to question, which in turn has led investors to BE In our opinion, OIS is a favorable alternative to LIBOR because the Rate is based on actual trades rather than through polls. While manipulation is still possible, we believe the hurdle is higher. Also, since the Rate is based on 1-day trades, there is less credit guesswork, making OIS swaps a more pure interest rate hedge versus the LIBOR swap, which is an interest rate plus credit hedge. Finally, since cash collateral on interest rate swaps earn the Rate, many dealers have already incorporated OIS into their LIBOR swap curves to price in- or out-of-the money swaps. However, due to the complexity of fitting two curves, dealer prices vary widely when it comes to pricing legacy swaps or even to quote vanilla forward rates or swap options. Much of this confusion would be eliminated by moving to a pure OIS swap. Criticisms of using OIS include wide bid/offer spreads, shorter traded maturities and seasonal patterns to the Rate. When LIBOR swaps were first introduced, bid/offers were wide and maturities were limited, as well. Over time, however, bid/offer tightened and maturity extended. Therefore, as OIS becomes more popular, these liquidity-related issues should resolve themselves. As for seasonal patterns, we believe predictability is actually a positive point as opposed to a rate where the underlying rationale is opaque and not well understood. Rates with predictable patterns should command a lower risk premium than less predictable rates as any excess risk premium on predictable rates will be extracted by traders who are willing to work to build seasonality analysis Page 1

2 into their models. In addition, Fed Funds futures are among the most liquid instruments in the world; they should help with the modeling of the OIS curve, at least on the front end. Liquid rates markets outlook Although the market was disappointed the Fed did not deliver QE3, the rates market barely moved following the announcement. The 10-year Treasury yield sold off only 3 basis points from the day before the Fed announcement to the end of the month. This market behavior is quite telling with regard to the demand for U.S. fixed-income assets. The migration out of debt issued by fiscally weak nations continued. Money is flowing into German bunds or other currencies perceived to be safer. The U.S. dollar is one such beneficiary of this movement, and both U.S. fixed-income and equity markets have done well this year due, in part, to this flow. In May the German 2-year bund traded at a negative yield. Can that happen here? No, we don t believe so, especially if the Fed maintains operation twist-like activities in which short-maturity securities are sold to buy long-maturity securities. However, in this environment, marked by investors who are more concerned with return of principal than return on principal, it is not inconceivable that the madness of negative nominal yields could occur. Securitized markets YTW Modified Duration Spread Duration Auto ABS Credit Cart ABS AGY Fixed Rate MBS 2.49% AGY Hybrid Arm 0.89% CMBS 2.88% Source: Barclays Capital Even though the Fed, at the June meeting, opted not to purchase additional MBS, MBS still had a good month, outperforming Treasuries and swaps. The thinking is that the Fed will maintain low interest rate volatility, which bodes well for mortgages. For the month, FNMA 30-year fixed-rate, current-coupon rate was down 2 basis points. In comparison, for the month, Treasury yields, on average, sold off 8 basis points, and LIBOR swap rates increased 2 basis points. FNCR 3.5s attractive vs. FNCL 3.5 TBA deliverable pools The second round of the Home Affordable Refinancing Program, known as HARP 2.0, went into effect December 1, As a result of HARP 2.0, LTV ratio limits for fixed-rate mortgages with terms up to 30 years have been removed; they were 105% maximum in HARP 1.0. New pools with these high LTV loans are not deliverable into TBA, and these pools have been given special prefixes by the GSEs: CQ and U6 for Fannie and Freddie pools, respectively, with LTV between 105% and 125%; and CR and U9 for Fannie and Freddie pools, respectively, with LTV > 125%. These pools started trading in mid-april of this year. Again, CQ/CR/U6/U9 pools are not deliverable into TBA. In addition, CR/U9 pools are not REMIC eligible, but are still CMO (IO/PO and floater/inverse) eligible. Of all the HARP 2.0 high LTV cohorts, we favor the >125% LTV with 3.5% coupon. In our opinion, these pools have an attractive convexity profile and the lowest premium of all the HARP 2.0 high LTV pools, which reduces the risk of additional refinancing policy initiatives. We ll focus our analysis here on FNCR 3.5s (FGU9 3.5s will be similar). Most of the loans in FNCR 3.5s have LTV > 15 and FICO score > 720. In order to qualify for HARP 2.0, the borrower must be current on mortgage payments for the last six months, with only one missed payment in months 7 to 12. So, even though their houses are significantly under water (hence LTV > 15), these borrowers have continued to pay, which explains the high FICO score. From an investor perspective, high LTV means there will be less turnover even if the housing market recovers as it will be a while before these borrowers are incentivized to sell the house because proceeds from the sale will not be enough to cover the loan. The high FICO score also means there is less chance of default or strategic default, which would ruin the borrower s credit. In addition, since these borrowers have gone through HARP once, they cannot HARP again if mortgage rates continue to drop (with > 15 LTV their chance of finding non-harp refinancing source is also limited), which means the prepayment speed will remain low even in a lower rate scenario. All in all, the prepayment speed should be very stable in both higher and lower rate environments, making the convexity profile of these pools attractive. We prefer 3.5s due to the lower dollar premium, which Page 2

3 also reduces some of the future policy risk associated with home refinancing. When FNCR 3.5s started trading in April, the pay-ups to TBA were around negative 4 ticks. As more of these pools were produced and more investors got comfortable with the cohort, the pay-ups have richened to around positive 8 ticks as of June month-end. At current market levels, we believe these pools are still fundamentally attractive relative to new-production, non- HARP FNCL 3.5 pools, which are those most likely to be delivered into TBA (more seasoned pools are even cheaper to deliver, but are mostly locked away at the Fed). We believe FNCR 3.5s are about 50 basis points cheaper than FNCL 3.5 TBA pools on a LIBOR OAS ( LOAS ) basis. Most of that LOAS differential is a result of the difference in option costs between the two cohorts. Based on the much more stable prepayment speeds in both sell-off and rallying scenarios of FNCR 3.5 pools mentioned above, their option hedging cost is about 35 basis points, running lower than FNCL 3.5 TBA pools, even though there is modest price difference between the two cohorts. Given that FNCR 3.5s are not deliverable into FNCL 3.5 TBA, and the prepayment speed for FNCR 3.5s is expected to be slower than deliverables for FNCL 3.5 TBA in virtually all scenarios, FNCR 3.5s have higher theoretical duration than FNCL 3.5 TBA. This means the pay-up should be positive, expanding in a rally, but negative in a sell-off. We estimate the duration of FNCR 3.5s to be around 9 years, and the duration of FNCL 3.5 TBA to be approximately 5 years. Securitized markets outlook The last great specified pool story was in 2008: credit-impaired or loan-balance FNCL 6.5s. Those pools prepaid at an average rate of 18% CPR since 2008, generating returns of roughly 4.9 per year since the fourth quarter of With the effective Fed Funds rate averaging only 17 basis points during that time period, both leveraged and un-leveraged investors did very well with those specified pools. We expect the next good specified story to be the high LTV pools mentioned above. The convexity profile of these pools is excellent. For example, after hedging with TBA and swaps, investors are basically long convexity at no cost. If the rates market experiences large movement in either direction, we believe these pools will perform very well. Municipal bonds In June 2012, the municipal bond market volatility was fairly low and, given the move in the liquid rates markets, municipal bonds generally performed as expected. For the month, the Bloomberg AAA G.O. curve increased 5 basis points on average. In comparison, for the month, Treasury yields sold off 8 basis points and LIBOR swap rates rose 2 basis points. 4% 0.35% AAA GO Muni Yields 6/29/ % 2.05% 3.56% MTD change (bps) Increasing subordination of state general obligation debt by special obligation bonds The prolonged economic downturn has exerted tremendous stress on most states coffers. In addition, increasing pension gap and decreasing federal funding further cloud their fiscal health. While the latest Supreme Court ruling made Medicaid expansion voluntary on the states part, those that choose to adopt the expansion face immediate implementation costs and future liability increases. For states that opt out of the Medicaid expansion, the cost for caring for the increasing number of uninsured will fall on county and local governments, which will have to raise property tax rates to pay for the rising cost of care. In these economic stressful times, some states have paid for programs by increasing the sale of special obligation bonds secured by first claims on future sales or personal income taxes or secured dedicated taxes. These activities, in our view, effectively subordinate a state s general obligation debt. Since sales tax and personal income tax contribute to the state s general fund, which is the source of payment for the state s general obligation debt, any first priority claims on these taxes to secure other debts reduces the amount available to secure general obligation debt. Similarly, if a state enacts or increases a special dedicated tax whose revenue stream is used to secure a special obligation debt, this may limit the state s ability to raise general Page 3

4 taxes as much as it wants to in order to make up for shortfalls in the general fund (in the limit, all taxes cannot add up to more than 10 of income). Therefore, again, issuance of debt secured by special dedicated tax indirectly subordinates the state s general obligation debt. Let s look at a few examples. In 1985, Illinois passed the Build Illinois Bond Act to expand the state s overall efforts in economic development through the funding of projects such as infrastructure, education, health and human services, business expansion and environmental conservation. Bond issuance is granted by this act to pay for these programs. Security for these Build Illinois Bonds comes from first and priority claims on sales tax receipts after netting out 21.75%, which is directed to local governments, certain state funds and another special project. Illinois issued $425 million of such bonds in May The Build Illinois Act originally authorized $948 million in bonds and $380 million from current tax revenue to support the state s various programs; the Build Illinois authorization has been adjusted several times to the current authorized level of $5.7 billion in bonds. These bonds are rated AAA/AA+ by S&P/Fitch, higher than the state s general obligation debt rating of A+/A by the same rating agencies to reflect the more senior nature of these Build Illinois Bonds over the state s general obligation debt. Part I of Chapter 383 of the Laws of New York of 2001, as amended periodically (the Enabling Act ), provides that 25% of the receipts from the New York State personal income tax shall be used to fund certain dormitory, environmental, housing, transportation and urban development programs. Again, bonds issued by the Enabling Act carry credit ratings of AAA/AA by S&P/Fitch, which are higher than or equal to the state s credit ratings of AA/AA by the same rating agencies. When the Enabling Act was first created in 2001, the 25% was calculated after excluding refunds owed to taxpayers and School Tax Relief Fund (the STAR Fund ). Effective April 1, 2007, New York legislature no longer nets STAR Fund before the 25% calculation; therefore, making the funds available for these programs larger. In fiscal year 2006 to 2007, total New York State personal income tax receipts net of tax refunds and STAR Funds was $30.6 billion and the STAR Fund was $1.8 billion. So, the 2007 amendment, which changed the calculation tax base by adding back the STAR Fund, had the same effect as changing the available percentage to 27. from 25% if the calculation tax base was unchanged. In June 2012, Michigan issued $2.9 billion of Unemployment Obligation Assessment Revenue Bonds ( Bonds ), which are secured by unemployment insurance tax paid by employers doing business in the state of Michigan. This tax rate is set and re-set at least annually in an amount sufficient to ensure full and timely payment of the debt service on these Bonds. Given the economic downturn, the state s payments for unemployment benefits have increased. To fund these current payments, Michigan has chosen to sell a portion of its future revenue stream from this unemployment insurance tax. If the economy does not recover quickly, Michigan may be forced to raise the unemployment insurance tax rate to cover future unemployment benefits obligations (remember, part of the future revenue stream has already been sold and spent and is no longer available). This will place an additional burden on employers in Michigan and limit the state s ability to raise corporate income tax, which contributes to the general fund. Therefore, again, these Bonds implicitly subordinate the general obligation debt of the state. Why don t states just issue general obligation bonds to finance all these various programs as opposed to the use of dedicated taxes or first liens on sales or personal income taxes? The main reason is that additional issuance of general obligation bonds would cause their yields to go up, which makes them more expensive to issue. In an efficient market, investors should take into consideration the subordination of states general obligation debt by these special obligation debts and demand higher yields. While this has not yet happened, if this trend continues, we anticipate investors will eventually wake up and widen out the spread between states general obligation bonds and their senior special obligation bonds. Major Negative Muni Rating Actions in June 2012 Stockton (CA) issuer rating was downgraded to D (default) from SD (selective default) by S&P on June 27, The city filed for Chapter 9 bankruptcy on June 28, Anaheim (CA) G.O. debt was downgraded to Aa2 from Aa1 by Moody s due to three consecutive years decline in the city s general fund. The fund s current balance is less than half of the 2007 peak. Rockland County (NY) G.O. was downgraded to BBB- from BBB+ by S&P due to continued erosion of the county's once strong reserves. S&P's new rating of BBB- is now equal to Moody's Baa3. Detroit G.O. was downgraded to CCC from B by Fitch on June 13, 2012, as the city stated the possibility of not making a debt service payment due on June 15, 2012 on its pension COPs. Page 4

5 Muskingum County (OH) G.O. was downgraded to Aa3 from Aa2 by Moody s due to declining general fund balance and cash reserves over the past four years. Puerto Rico s BBB rating outlook was revised to negative from stable by S&P, due to a challenging economic and fiscal environment, which has the potential to delay a transition to structurally balanced budgets beyond fiscal In addition, the funded ratio of Puerto Rico s pension system is extremely low at 6.8% as of June 30, The system s net assets would be exhausted in 2014 and all available assets would be exhausted by fiscal Moody s downgraded 1,675 specific municipal securities backed by dedicated support facilities provided by one of the 15 downgraded banks on June 22, 2012, a day after Moody s downgraded 15 banks with global capital market operations. The downgraded municipal bonds totaled $45 billion. The bonds are supported by letters of credit, standby bond purchase agreements and other liquidity facilities Total returns for fixed income sectors YTD 4.7% % 1.8% 1.5% Muni (AAA) Agency Securitized Treasury Corporate Source: Barclays Capital Major Positive Muni Rating Actions in June 2012 Waterbury (CT) G.O. was upgraded to A from A- by S&P due to the city s consistent and improved financial operations in recent years. Municipal bond market outlook Demand for municipal bonds was high in June, as record redemptions overwhelmed supply. According to Citigroup research, from May through July municipal bond redemptions from debt maturing or being called will be around $142 billion, a record for a three-month period. The May and June supply totaled $79.6 billion, according to Securities Industry and Financial Markets Association ( SIFMA ) data. Municipal supply year-to-date has exceeded last year s level, for the same time period, by roughly 46%. Assuming the trend continues through July, July s supply will be approximately $33 billion, bringing the total supply from May to July to $113 billion, far short of the $142 billion of redemptions. This supply/demand dynamic should keep munis well bid into July; however, conversations with dealers indicate that the supply calendar is building strongly for the fall. If the redemption issue is cleaned up by then, munis may cheapen relative to liquid rates in the fourth quarter of this year. David Ho, Managing Director dho@fpcmllc.com Rongfeng Becky Li, Vice-President, CFA bli@fpcmllc.com 2012 First Principles Capital Management, LLC 140 Broadway 21st Floor New York, New York Page Tel Fax