Agencies lag Treasuries amid light profit-taking, late risk hedging; callables active

By Kenneth Lim

Boston, Aug. 19 - Agency spreads widened slightly Friday on light risk-off trading heading into the weekend, although yield-starved investors remained eager to pick up callables.

Bullet spreads eased out by about 1 basis point against Treasuries across the yield curve.

There was "nothing too significant in bullets," a trader said.

Trading in bullets was slow ahead of the weekend and with many market participants on vacation.

Yields hold firm

Yield levels rose a little at the start of the day as investors took profit from Thursday's sizable rally, but yields then fell back toward the close as the market hedged against potential negative news over the weekend.

"Treasury markets rallied a little bit, but not substantially," the trader said. "I think the market's just trying to figure things out."

Investors were initially concerned about news from earlier in the week about European banks possibly being under pressure. One report said a European bank had had to borrow money from the European Central Bank, and another report said the U.S. Federal Reserve was concerned about the euro zone debt crisis possibly having some spillover effects in the United States.

"There was a lot of volatility last night with concerns about European banks," the trader said. "Everybody came in this morning wondering what was going to happen."

Going into the weekend, investors were worried that more negative headlines would emerge out of Europe before the markets reopen Monday.

"Obviously we still have the concern that there's going to be some type of crisis in the European market, either a country or a bank," the trader said.

Callables in demand

Despite the relatively lackluster trading in bullets, callable issuance and trading have been robust, fueled by the recent drop in yields and expectations that front-end interest rates will remain low for the next two years.

The low-yield environment has prompted issuers to redeem existing callable issues as soon as they can, with billions of dollars called every day over the past week.

"Bonds are being called away at a good pace, and [Federal Home Loan Banks] and [Federal Farm Credit Banks] have been holding auctions every day," the trader said.

That has put money back in the hands of investors, who need to reinvest that money and are willing to buy callables again because they offer better yields than bullets. The search for yield has also been pushing investors farther out on the yield curve, with many new issues in the five-years and longer sectors.

"I think a lot of people are having to buy just because of the number of bonds that are being called away," the trader said. "People are forced to reinvest...and most accounts are trying to grab as much yield as they possibly can by pushing out the curve."

Over the past week, callables have been dominating the agency market.

"There are still a lot of callable issues coming into the marketplace, and that's probably the biggest story in the market now," the trader said.

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