Agency spreads track swaps, widen; FHLB's two-year Global Notes start strong, finish flat

By Kenneth Lim

Boston, March 18 - Agency spreads widened on Thursday as new supply from Federal Home Loan Banks arrived in the two-year sector.

Bullet spreads shifted out by about 1 basis point in the two-year sector while staying unchanged in three-years, said Craig Ziegler, an agency trader at Broadpoint. Five-year and 10-year spreads also widened a touch.

Agencies were mostly reacting to swaps, which have been active because of the large amount of corporate issuance. As investors seek to swap the new bonds, swap spreads tighten, Ziegler explained.

"It's kind of a monkey-see, monkey-do day," he said.

Swaps have been outperforming agencies recently, but that is more a reflection of the different amounts of activity rather than value of the two markets, Ziegler added.

"Swaps have been so deal driven," he said. "It's just the flurry of activity...That's been the driver. It hasn't really been a matter of the value of agencies versus swaps."

Callable issuance was strong at the front end of the curve.

"Three-years and under, that's where the main bulk of the interest continues to come," Ziegler said.

FHLB sells two-years

FHLB's new 1.125% Global Notes due May 2012 tightened slightly on their first day of trading but closed flat at a bid spread of about 21 bps over Treasuries.

The $3 billion deal priced at an initial spread of 21 bps over Treasuries, according to a press release.

The notes sold at 99.964 to yield 1.142%. Price talk was at a spread of 22 bps over Treasuries.

BNP Paribas, Barclays Capital and Deutsche Bank were the lead managers.

"They traded well," said Ziegler, who noted that the deal came at a 2 bps concession to surrounding issues. "They immediately traded better, got as rich as 20 bps and closed at 21 bps, 20 bps as rates kind of settled down. It could have traded even better."

In a statement, FHLB said the deal was "oversold within hours."

U.S. investors bought 72% of the notes offered, while Asian investors took 18%. Investment advisers and fund managers were the largest bloc, accounting for 54% of sales, followed by central banks with 25% and financial institutions with 15%.

Another agency trader said the deal did well partly because there is a shortage of cheap paper in the sector.

"Spreads are already so tight in two-years and it doesn't look like it's going to change very much because it's basically guaranteed paper now," the trader said. "Any kind of a concession you can get there, people are going to leap on it."

Possible widening ahead

The trader said the week ahead could see even more widening because the Federal Reserve will be ending its agency debt buying program.

The last purchase operation is expected in the week of March 22.

"I think that's the big shadow hanging over the market right now," the trader said. "There's no surprise there, but there's still some uncertainty about how much the market is going to miss having the Fed around. I do expect to see some more widening next week."

The trader said longer-dated agency paper will feel the change more than shorter-term notes, which have benefited from the Treasury's strong support for Fannie Mae and Freddie Mac over the next three years.

"The curve is going to steepen further, and I think you're going to see quite a bit of disparity between agency paper that's three years and shorter than agency paper that's longer than that," the trader said. "I think that's going to be a persistent reality for quite a while."

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