Agencies tighten on Fed support; three-year sector appealing, say Barclays analysts

By Kenneth Lim

Boston, July 24 - Agency spreads tightened on Friday as buying from the Federal Reserve helped to arrest a two-day expansion, while Barclays Capital analysts said it may be time to move a little further out on the yield curve.

Bullet spreads moved in slightly across the curve on a slow Friday, an agency trader said.

"Not much going on today," the trader said. "The Fed had their usual buybacks, that's providing some support as usual, mostly on the front end today."

The Federal Reserve Bank of New York on Friday said it bought $3.235 billion of agency debt due 2011, 2012 and 2013 as part of its open-market operations. That is about half the $5.883 billion of paper offered.

"I think it was a decent amount," the trader said.

Barclays recommends three-years

Three-year spreads can be compressed further, and the sector looks particularly attractive now with two-years about as tight as they can be, said Barclays Capital's agencies research team in a note.

The Fed is expected to buy almost $100 billion of agency securities in the remainder of the year, wrote analysts Rajiv Setia, James Ma and Philip Ling.

Most of that buying will likely be focused on front-end issues because selling interest in long-end operations is waning. Also, the Fed does not want to affect liquidity too much, and the biggest individual issues in the market are currently two- and three-year notes.

Front-end issues could approach single-digit spread levels versus Treasuries because of the Fed purchases, even though two-year spreads are already hovering around 10 to 15 basis points over Treasuries at the moment, the analysts wrote.

That leaves the three-year sector particularly "ripe for further spread compression," the analysts said.

"Investors can pick up 15 bps by extending from active FHLMC 2s to 3s, but are rewarded only another 4 bps for extending from active FHLMC 3s to 5s," the analysts wrote. "The current 2s-3s spread curve pickup of about 15 bps is also at the high end of the long-term historical range."

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