MARKET MOVER - BNP PARIBAS - Investment Services India

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
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