Agencies widen as Spain downgrade drives funds to safety; sour end to lackluster month

By Kenneth Lim

Boston, May 28 - Agency spreads widened on Friday as a downgrade of Spain's credit rating reignited a flight to quality just before the long weekend.

Bullet spreads closed about 1 to 2 basis points wider across the curve, said Ted Ake, managing director of U.S. Treasury and agency trading at Societe Generale.

"Spreads were out a couple this afternoon," he said, "part of it on the uncertainty about what's going on in Spain and Korea."

Another trader said trading volumes were slow in general.

"It was kind of quiet," the trader said. "[It's] not a surprise with the short day and the three-day weekend coming up. It's kind of a holiday mood around here."

Even callables seemed to be quieter than usual.

"I did see a bit of trading in callables, but I think it was hard to do anything substantial with half the people already out the door," the trader said.

Spain spooks market

Investors retreated into safer positions on Friday as Fitch Ratings downgraded Spain's credit rating by one rung to AA+ from AAA, citing the country's mounting debt.

The news sent funds scurrying for less risky investments, such as Treasuries, and away from spread products, the trader said.

"The downgrade really just set the mood for the whole day," the trader said. "We had a bit of a relief yesterday when the stock market picked up, but I think today was a big reminder to the market that we're still deep in a period of uncertainty."

The idea that Spain's credit ratings were vulnerable was not really a surprise after Greece and Portugal also had their ratings downgraded, the trader said. But it drove home the point that the debt crisis in Europe is far from being resolved.

"I think Spain has been kind of on the bubble," the trader said. "So was it a big surprise? No. But it's still a negative piece of news. It means that there's not a lot of confidence that Europe can contain its credit problems, and that's a scary thought to have going into the long weekend."

Down end to down month

At least Friday's widening was consistent with the general widening trend over the past month, which saw agencies underperform Treasuries amid concerns about Europe's debt crisis.

"Nothing outperformed Treasuries," the trader said. "We can only take comfort in the fact that we outperformed swaps, but keep in mind there was a period when swaps tightened dramatically and we were underperforming swaps."

Most investors will enter the weekend with a neutral position, the trader said.

"People are just going to lighten up their positions, come back on Tuesday and see what happens," the trader said. "I don't think there's enough confidence either way to take any kind of a strong position."

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