Fixed Income Market Commentary

Transcription

1 First Principles Capital Management April 2012 Fixed Income Market Commentary Liquid rates markets In April 2012, Treasuries reversed two months of sell-off, rallying 21 basis points on significantly lower than expected nonfarm payroll print, which ignited economic double-dip fears and landed the Fed s QE3 back on the table. For the month, LIBOR swap rates dipped 17 basis points, and TIPS real yields rallied 6 basis points. 4% MTD change (bps) % Y 5y 10Y 30Y 1.75% -1.48% Treasury Yields 4/30/2012 TIPS/Breakeven Yields 4/30/ % -1.26% -0.34% Yields 2.26% 2.38% 0.74% MTD Real Yields change (bps) BE Interest rate volatility indicates yields will drift lower near term Since the beginning of 2010, interest rate volatility and yield changes have been positively correlated: as yields climb, so do volatility measures. This movement is reasonable, as Fed actions have pushed both short- and long-term rates to extremely low levels. If growth and inflation remain docile, and the Fed continues to enact its extremely accommodative policies, rates will either hover at their current levels or slowly grind lower. In either scenario, realized volatility should be low. However, if growth and inflation pick up and the Fed is forced to tighten monetary policy, rates will rise quickly and volatility will increase. The front end of the yield curve is the most sensitive to Fed policy. Since the Fed has already indicated that it will likely maintain a low fed funds rate low until late 2014, that part of the yield curve should be especially sensitive to expectations of Fed policy, particularly If these events exist: economic data beats expectations and the market starts pricing in the probability of an early removal of the Fed s accommodative policy. Let s look at the volatility of 3-month LIBOR rates 2.5 years forward, right near the cusp at which the Fed believes its easy monetary policy will end. If we first consider the daily basis point volatility ( bpvol ) implied by the market for this interest rate option then plot it against the 10-year swap rate (see Graph 1 on next page), we make two key observations: While rates have returned to recent lows, volatility has not. We interpret this as short-covering in rates, which has driven down rates, while more bearish positions are being added via options. Rates and volatility are coincident for most of 2010 and 2011, and volatility picked up before rates moved in We anticipate rates to remain low and realized volatility to continue to drag down implied volatility until it gets close to, or even through, prior lows. At that time, we expect a pick-up in volatility from the lows, as a leading indicator and would look to position for higher rates. Page 1

2 Liquid rates markets outlook Last month we expected QE3 to be back on the table following the market discounting a lower probability of QE3 in both February and March. While we do not expect the Fed to follow through on implementing QE3, because of both moderate growth and criticisms around prior QE efforts, the market will trade as if QE3 were a done deal in advance of the June 20 FOMC statement release, making it a prudent time to initiate a short position. If the Fed does implement QE3, the upside in Treasuries should be limited. Conversely, if the Fed does not commit to QE3, a quick sell-off is likely. Growth worries, however, might pull yields down slowly, in expectation of QE3 s arrival at a later date. Graph 1: Implied interest rate volatility of 2.5Y->3M option versus 10-year swap rate USSW10 Securitized markets Data source: Bloomberg and JPMorgan Chase YTW bpvol Modified Duration Spread Duration Auto ABS 0.94% Credit Cart ABS 1.36% 3.97% 3.97% AGY Fixed Rate MBS 2.64% 3.48% 4.19% AGY Hybrid Arm % CMBS 2.86% Source: Barclays Capital In April 2012, agency fixed-rate MBS rallied along with its liquid rates product counterparts. Agency MBS performed in line with Treasury yields and outperformed LIBOR swap rates. For the month, FNMA 30-year fixed-rate current-coupon rate dropped 22 basis points. In comparison, for the month, Treasury yields rallied 21 basis points, and LIBOR swap rates dipped 17 basis points BP FNCL 4.5s good short candidate Agency 30-year fixed-rate MBS have generated impressive performance this year relative to its liquid rates product counterparts. For example, year to date, Treasuries sold off 6 basis points, LIBOR swap rates are 2 basis points lower, and the FNCL current coupon rate is down 4 basis points. Mortgages richened considerably in the fourth quarter of 2011 fueled by QE3 expectations, where purchases will likely be focused on MBS. Improved economic data in both February and March decreased the probability of QE3 and widened mortgage spread. However, the weaker than expected employment picture combined with renewed focus on Europe s fiscal crisis reignited expectations of further Fed intervention. We expect an announcement at the June 20 FOMC statement release as to whether or not the Fed is going to enact QE3. This timing nearly coincides with the end of Operation Twist program, and furthermore, it will not interfere with election politics, which will heat up later this year. In our view, the probability of QE3 in June is less than 50/50, as opposed to the market s current expectation of greater than 50/50. Both the Fed s March and April statements were cautiously optimistic regarding growth and employment. Since the April statement, the most significant event, outside of the Fed s ongoing dovish communication, has been the decline in oil and gasoline prices. However, we don t believe that this, or any one factor, would prompt a QE3 enactment without further evidence of a material slowdown in the US. In addition, while the Fed historically has hinted about quantitative easing initiatives before implementation, there has been no such foreshadowing this time around. The market likely will continue to build in higher expectations of QE3 until the June Fed meeting and then be disappointed when the Fed holds off on further large-scale asset purchases or duration extension programs. However, it s not a given that MBS will sell-off as the Fed might sound more dovish in June than in April, and the market might pin its hopes on Fed action later in the year, despite election politics. Regardless of the outcome of the Fed meeting, mortgages are currently pretty close to being priced for perfection. While the market does not widely expect a major MBS sell-off this year, there is a non-trivial probability of such an event. For those seeking to benefit from this tail event, FNCL 4.5s are a good short candidate. Like most coupons, FNCL 4.5s are at the highest historical dollar prices (see Graph 2 on the next page). The Fed, however, has not been purchasing FNCL 4.5s recently because they are not the current production coupons, and if the Fed enacts QE3, it most likely will not purchase them. In Page 2

3 addition, there is a decent amount of float of FNCL 4.5s outside the Fed s holdings, making a squeeze less likely. As illustrated in Table 1, float net of the Fed s System Open Market Account ( SOMA ) for FNCL is greater than for GOLD in all coupons, which makes FNCL less susceptible to squeeze than GOLD. Despite the larger float of FNCL 4.0s compared to FNCL 4.5s, if the Fed does enact QE3, their fire power will be focused on 4.0s and 3.5s, and float net of SOMA will be drastically reduced for those coupons. Therefore, from a deliverable and demand technical perspective, FNCL 4.5s are a safer short than other coupons. In terms of valuation, dealer models range from LIBOR optionadjusted spread ( LOAS ) of 3 to 30 basis points, depending on their speed assumptions, with current valuations in the low LOAS camp. At that LOAS, the average life ( AL ) for FNCL 4.5s is around 2.6 years, and the yield to AL is around 1.6. Hedging the prepayment and extension risk of this coupon with options would cost 80 basis points running, leaving the investor with roughly 80 basis points. Historically, the option hedging cost would be north of 100 basis points, but as discussed in the liquid rates section, implied volatility has been dropping, meaning option costs have come down. Graph 2: Historical price of FNCL 4.5s Jan-10 Oct-10 Jul-11 Apr-12 Let s look at a couple of ways an outright short FNCL 4.5 position can play out positively, in addition to a general sell-off in rates or widening in mortgage spread. One scenario: Implied volatility increases dramatically, which should benefit a short fixed-rate MBS position, which is long convexity/vega, by pushing down the MBS prices. A second scenario: Congress extends the HARP eligibility date to mid-2010, as has been proposed by Senators Barbara Boxer and Robert Menendez. This event, albeit a low probability, would significantly drive up prepayment speeds in FNCL 4.5s, as 4.5s were the biggest production coupon in late 2009 and early Of course, an outright short FNCL 4.5 position could be negatively impacted by a continued decrease in volatility, QE3 by the Fed, significant slowdown in prepayment speeds due to servicer bottleneck or just a good old-fashioned squeeze. In our opinion, since much of these fears have been built in to the MBS market, the impact on the MBS market, should one of them occur, would be limited. Table 1: FNCL and GOLD float (net of CMOs) net of Fed s System Open Market Account ( SOMA ) holdings (millions): FNCL Float SOMA Float- SOMA GOLD Float SOMA Float- SOMA < ,134 44, ,983 <4.0 72,051 24,702 47, ,026 96, , ,293 51,859 86, , , , , , , ,419 67, , ,433 68,380 69, ,855 48, , ,978 7,501 75, ,183 7, , , , , , , ,984 Data source: Federal Reserve Bank of New York and Barclays Securitized markets outlook The agency MBS market resembles the 2006 market for subprime mortgage, where virtually nothing could go wrong with non-agency MBS. Until then, housing prices increased, multiple rating agencies stress-tested the structures, and they were bullet proof. Today, the elevated agency MBS prices are justified by the bottomless housing market, inability of borrowers to refinance and overwhelmed banks. And, of course, the Fed is expected to come to the rescue with another round of purchases for every new or recurring crisis, domestic or abroad. The agency MBS market quite likely will end poorly, just as the non-agency MBS market did. In addition, we expect history to repeat itself, meaning there will be very few winners (among a sea of losers) who have the fortune to perfectly time the exit. Page 3

4 Municipal bonds 4% 0.3 MTD change (bps) In April 2012, municipal bonds rallied, performing roughly in line with other liquid rate markets on a beta-adjusted basis. For the month, the Bloomberg AAA G.O. curve was down 13 basis points. In comparison, for the month, Treasury yields rallied 21 basis points, and LIBOR swap rates dropped 17 basis points. Cost basis of tax-exempt municipal bonds The cost basis of fixed-income assets should be tracked carefully to ensure proper accounting, which distinguishes ordinary income from capital gains. In the case of tax-exempt bonds, cost basis can also track the amount of federally tax-exempt income, so it s important to accurately track the cost basis for each bond. Let s examine the proper cost basis for bonds bought at a discount and at a premium. Discount bond cost basis: AAA GO Muni Yields 4/30/ % There are several scenarios for bonds bought at a discount, including the proper cost basis for each. Here, we define discount bonds as those bought at price less than par ($100). Bond issued at par or at a premium (>= $100), but was bought for less than $100: The default cost basis should be only the purchase price. If the bond is held to maturity, the amount of discount will then be taxed. For individuals, the applicable tax rate will be determined by the de minimus tax rule. If at the time of purchase, the price of the bond was at a discount less than a quarter point per year until maturity, the discount would be taxed at the capital gains tax rate; if the discount on the bond was greater than or equal to a quarter point per year until maturity, the discount would be taxed as ordinary income. Bond issued with an original issue discount ( OID ) and was bought at a price less than par but greater than the accreted value of the bond from issuance at the OID yield: The cost basis should be adjusted for the accretion of the discount using the purchase yield. The accretion of the discount is not taxable and serves to increase the cost basis only. Bond issued with an OID and was purchased at a yield that is equal to, or higher than, the OID yield: The cost basis is the purchase price adjusted for the accretion of the OID amount based on the OID yield, and the portion of the discount attributable to the OID should be exempt from tax. Only the discount amount in excess of the OID should be taxable upon maturity if the bond is held until then. Again, for individuals, the de minimus tax rule applies with the OID price accreted at the OID yield, instead of par, serving as the base for the quarter point a year calculation. Premium bond cost basis: Bond bought at a premium (greater than $100) at a yield lower than original issue yield: The cost basis should be adjusted for amortization of the premium using the purchase yield. Suppose the bond is sold prior to maturity; if the sale price is higher than the cost basis, the difference should be taxed as capital gain. If the sale price is lower than the cost basis, the difference should be credited as capital loss. Bond bought at a premium at yield higher than original issue yield: The cost basis should be adjusted for amortization of the premium using the purchase yield. Even though the purchase yield is higher than the original issue yield, since the bond was purchased at a premium still (actually the same applies if the bond was purchased at par), the entire purchase yield will be exempt from tax. As always, we recommend consulting a tax professional regarding tax-related calculations. Major Positive Muni Rating Action in April 2012 Buffalo (NY) general obligation debt was upgraded to A1 from A2 by Moody s, due to significant improvement of the city s financial operations and liquidity. The upgrade affects $238 million outstanding debt. Page 4

5 Major Negative Muni Rating Action in April 2012 San Jose (CA) general obligation debt was downgraded to AA+ from AAA by S&P. Alamance County (NC) G.O. was downgraded to Aa2 from Aa1 by Moody s, as major revenue sources remain pressured. Jefferson County s (AL) $200.5 million outstanding general obligation debt was downgraded to Caa3 from Caa1 by Moody s on April 3. The county s $83.6 million outstanding lease revenue warrants were downgraded to Ca from Caa2. The downgrade reflects expected default on the county s fixed rate G.O. warrant debt service payment due April 1. The county has been in default on its variable rate demand G.O. bank warrants. This is the first default on county fixed- rate G.O. warrants. Puerto Rico Sales Tax Financing Corp s senior and subordinated sales tax revenue bonds were put on review for possible downgrade by Moody s. The review for downgrade was driven by Moody s recent U.S. public finance special tax methodology change published on March 27, The review affects $6.8 billion senior debt (Aa2) and $9.2 billion subordinated debt (A1) Total returns for fixed income sectors YTD 3.5% 1.8% 1.4% Muni (AAA) Agency Securitized Treasury Corporate Source: Barclays Capital Municipal bond market outlook As other yields largely converge toward zero, municipal bonds will appear increasingly attractive compared to their liquid rate product counterparts from a yield ratio perspective, although not from a historical credit spread vantage point. For example, longmaturity California general obligation debt currently trades at roughly Municipal Market Data AAA curve ( MMD ) plus 105 basis points versus MMD plus 140 basis points in November Similarly, long-maturity City of Chicago general obligation debt currently trades at roughly MMD plus 85 basis points compared to around MMD +135 basis points in November 2011, barely six months ago. These two issuers fundamentals have not materially improved from the time they traded at a wider spread, yet investors are notably more confident. In our view, investors generally are not sufficiently compensated for assuming significant credit risk, and we believe investors would be prudent to migrate to high quality names in this environment. David Ho, Managing Director dho@fpcmllc.com Rongfeng Becky Li, Vice-President, CFA bli@fpcmllc.com 2012 First Principles Capital Management, LLC 140 Broadway 18th Floor New York, New York Page Tel Fax