Agency spreads narrow as Freddie Mac reopens five-year notes; Fed to purchase at long end

By Kenneth Lim

Boston, Jan. 28 - Agency spreads tightened slightly on Thursday as a well-received reopening by Freddie Mac and a coming purchase operation by the Federal Reserve Bank of New York gave the market a broad boost.

After weakness the previous two days, bullet spreads were seen slightly tighter by about 1 to 3 basis points across the yield curve on Thursday, with issues that are five years and out doing slightly better.

Agencies had come under pressure since the week before, when Rep. Barney Frank said the House Financial Services Committee, which he chairs, will probably recommend abolishing Fannie Mae and Freddie Mac. Treasuries also rallied, while swap spreads widened. That led spreads to shift outwards by about 3 to 4 bps, an agency trader said.

"We've retraced about half of that move," the trader said. "Part of it is Treasuries trading off. Part of it is the buyback announced today [by the Fed]."

Trading volumes remained muted in bullets, although callable trading remains robust, the trader said.

"On the bullet side it's terrible," the trader said. "On the call side it's a little more than we've seen."

Callable yields in demand

A "fair amount" of callables were issued on Thursday, and investors continue to be hungry for structured products, the trader said.

Callable notes are pricing rich compared to bullets, the trader added, but some investors remain attracted by their favorable yields.

"It still seems to be a yield play," the trader said, with "guys hoping to pick up incremental yield."

But the potential yields hinge greatly on investors picking the right structure, the trader added.

"I see clients who normally wouldn't buy callables buy short, final maturities but also short lock-ins," the trader said. "I'm looking at these things, and if the market trades down, they would underperform massively, but if the market trades up they outperform significantly. But some of these guys are at big firms and they're really smart guys, and they feel confident about taking the view."

Freddie Mac sells five-years

Freddie Mac's 2.875% Reference Notes due February 2015 widened slightly on Thursday after being reopened at a spread of 28.5 bps over Treasuries.

The $1 billion reopening priced through an auction at 100.748022 to yield 2.714%. The bid-to-cover ratio was 3.86 to 1.

The outstanding amount under the series is now $5 billion.

"They came around 0.6 or 0.7 bps through the offered side," the trader said.

Some portions of the market had been expecting a two-year deal, and Freddie Mac's decision to sell five-years helped the two-year sector to end the day slightly narrower, the trader said.

"There was a little chat that they would do a two-year so that helped in that sector," the trader said.

Fed to buy at long end

The Fed will buy agency notes due October 2016 to July 2032 on Friday as part of its outright coupon purchase program, according to a press release Thursday.

The Fed has already bought about $162 billion of agency paper under the $175 billion program, which will end by March 31. The central bank has said it will taper the operations as the program comes to a close.

The exit of the Fed could help to improve liquidity in bullets, the trader said.

"At the end of the Fed buybacks in March, I would expect to see bullets trading better because we should see more two-way flow," the trader said. "Right now you're just selling to the Fed every week."

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