MARKET MOVER - BNP PARIBAS - Investment Services India

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This section is classified as non-objective research QE Impacts on Spread Sector Relative Value • Steep MBS demand from the Fed in the face of negative net MBS issuance has driven MBS to negative Treasury OASs. While we expect MBS to further outperform Treasuries, riskier asset classes, particularly corporate bonds, with their similar credit quality and liquidity, are likely to do even better. • A broad range of global debt investors who employ benchmarks will face asset shortages in the face of this QE-induced contraction in available investment grade assets. This is expected to provide technical support to US IG credit, despite low yields and historically full valuations, and will help to perpetuate the current strong demand for high-quality new issue paper. High yield and emerging markets credit also benefit from this dynamic. • This incremental demand from non-credit sectors combined with significant re-investment cash flows from the shrinkage of the large bank balance sheets is expected to drive relative outperformance of bank/finance bonds, quasisovereign/yankee securities and select BBB's over the next 6 months. MBS Rich as Demand Far Outstrips Supply Our economists expect QE3 MBS purchases to continue at the USD 40bn per month pace at least until year-end 2013, and possibly tapering into 2014. Including reinvestments of maturing agency debt in the Fed's portfolio into agency MBS, the net demand from the Fed would exceed USD 500bn over the next 12 months. The issuance of the TBA deliverable bonds where Fed purchases have been concentrated was negative USD 172bn over the past 12 months, roughly a negative USD 14.3bn per month average. Thus, the Fed demand for MBS is particularly high in relation to the negative supply of the bonds that the Fed has traditionally purchased. This has driven MBS to very expensive levels (as seen in Chart 1). The chart, which shows the history of the current coupon + 50bp OAS vs the on-the-run Treasury curve, indicates that MBS have richened to a greater extent than during QE1. While this massive, initial tightening brought in some selling, MBS were back to outperforming Treasuries on Wednesday in the rally. Note that the current coupon is a theoretical par priced coupon that is traditionally used as a benchmark for valuation purposes. Chart 1: FNMA MBS Current Coupon + 50bp Treasury OAS – Treasury OAS Negative 160 (bp) 140 120 100 80 60 40 20 0 -20 QE1 -40 Dec-08 Sep-09 Jun-10 Mar-11 Dec-11 Sep-12 Source: BNP Paribas Chart 2: BIG Credit Spread to Libor vs Current Coupon + 50bp Libor OAS – Corporates wide vs MBS 500 (bp) 450 400 350 300 250 200 150 100 50 QE1 QE2 0 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Source: BNP Paribas Chart 3: Freddie Mac Portfolio Size vs Outstanding Debt – Debt Declined in Sympathy With the Portfolio Size 1,050 $ bn 950 850 750 650 Portfolio Debt Outstanding 550 Aug-08 May-09 Feb-10 Nov-10 Aug-11 May-12 Source: BNP Paribas Bulent Baygun / Anish Lohokare / Mark Howard 20 September 2012 Market Mover 24 www.GlobalMarkets.bnpparibas.com
This section is classified as non-objective research Recently, however, as MBS yields have come off considerably, primary mortgage rates offered to borrowers have not declined as much. Thus, origination occurs mainly in the 3% coupon, with reasonable pricing available for the 2.5% coupon. With the current coupon calculated at 2.02% as of Wednesday close by Bloomberg and the lack of availability of market pricing for the 2% coupon, we consider current coupon + 50bp a better benchmark than the current coupon itself. Fed Purchases at the Expense of Money Managers and GSEs The Fed would effectively be buying from money managers who are overweight MBS and GSEs, who have been forced to reduce their portfolios. Rather than explicit sales of MBS, we mainly expect reinvestments of mortgage prepayments into other products. The latest Federal Reserve Z1 report shows that mutual funds hold about USD 1.36trn in agency debt and MBS; while the breakdown is not available, we expect the share of MBS to be much larger than debt akin to their relative sizes in the bond market (USD 5.6trn agency MBS vs USD 2.3trn agency debt). We estimate that money managers could experience USD 150bn to USD 200bn in prepayments that could be reinvested in other asset classes over the next 12 months. From a similar credit and liquidity perspective, investment-grade credit seems a very likely choice for the reinvestments. In Chart 2, we show the difference between the Citigroup Broad Investment Grade Credit Index spread to libor and the current coupon mortgage Libor OAS. The chart shows the spread between corporate bonds and MBS has widened 25bp following the QE3 announcement. While the spread differential remains more than 40bp from its November 2011 wides, the level still appears attractive enough to effect a reallocation from MBS into corporate bonds. Notably, while mortgages are trading more than 10bp through their QE1 tights, corporate bonds in relation to MBS remain 70bp wide of the tights reached during QE1 and again during QE2. Note that we expect MBS to tighten further, albeit gradually, and outperform Treasuries. But, given the performance the product has already put in after the QE3 announcement, we think that riskier asset classes, particularly corporate bonds whose valuations have yet to reflect this incremental demand, are likely to do better going forward. A similar case was observed during QE1 when mortgages reached very tight levels and ran into a roadblock in May 2009 (Chart 1). Subsequent QE1 MBS purchases fuelled mainly other asset classes. Chart 2 shows that during QE1, the spread of corporate bonds to MBS widened until early March 2009, even as the MBS spread to Treasuries tightened during that time. But, as MBS purchases continued, further tightening in MBS was fairly incremental, but the spread of corporate bonds to MBS ground steadily tighter. Thus, while the first stage of QE1 was MBS tightening, the second stage involved the transmission of demand to other asset classes, leading corporate bonds to outperform MBS. Another factor, not directly related to QE3 but likely to help other asset classes, is the shrinkage of GSE portfolios. As the Treasury announced in August 2012, GSE portfolios will now reduce at a 15% rate every year from a USD 650bn base as of 31 December 2012, instead of the previous 10%. As Chart 3 shows, the decline in GSE portfolios has also caused a reduction in GSE debt outstanding that funds these portfolios. As the shrinkage of GSE debt outstanding accelerates, we estimate that USD 50bn to USD 200bn could be freed up over the next 12 months to be reinvested in other asset classes. US Corporate Bonds are a Likely Beneficiary Although it is unlikely that all of these investments will migrate into credit over the next year, we expect these flows to drive incremental demand for US IG credit. The overall US corporate bond market is approximately USD 8trn, according to SIFMA, with USD 4.5trn par value outstanding for index eligible debt. Approximately USD 350bn of index-eligible corporate debt is expected to mature in 2013, and we estimate that an additional USD 275bn of non-index eligible debt will mature, as well. Some USD 250bn of par value of long-term index-eligible debt was removed from the market in 2012, likely due to calls or tenders. Factoring in new institutional credit inflows and other sources of demand, we estimate that mortgage investments could increase assets allocated to credit by at least 10-15% over the next 12 months. The incremental demand for credit will flow into the primary and secondary markets. IG corporate issuance has topped USD 750bn year to date, despite the 14% decline in financial supply, and high yield issuance is a record USD 220bn-plus. Absent a material reversal in economic conditions, we believe that companies will continue to enthusiastically access the corporate bond market. Despite well-documented declines in dealer liquidity provision to corporate bonds, 2012 trading volumes (based on par value traded) have averaged USD 17bn per day, or USD 4.25trn annually. For investment grade corporate bonds, which would be the most likely beneficiaries of a reallocation of funds, we estimate that 2012 annual trading volume will approach USD 3trn. The mortgage flows would Bulent Baygun / Anish Lohokare / Mark Howard 20 September 2012 Market Mover 25 www.GlobalMarkets.bnpparibas.com
Page 1 and 2: Market Economics | Interest Rate St
Page 3 and 4: Spain set to present its new budget
Page 5 and 6: The methodology All of the above in
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Page 9 and 10: Spain: Inching Closer to a Request
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Page 13 and 14: US Housing: New Channels for Policy
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Page 55 and 56: Treasury and SAS Issuance Calendar
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