Market Outlook - BNP PARIBAS - Investment Services India

This section is classified as non-objective researchUS: Agencies Best Value in Rates, Swaps Lag• There has been a migration of both realmoney and fast money investors into theagency space in recent weeks. Real moneyinvestors who were already active in theproduct have increased their allocations. Thelow yields in Treasuries hurt total return.Agency bullets and callables can easily doubleTreasury yields, particularly in the short end.• Some fast money investors looking to pickup yield and improve performance havereturned to callable agencies. They offer amongthe highest yields for AA+ rated products, thespread risk is minimal - particularly comparedto mortgages in recent weeks, Furthermore,agency haircuts and repo are quite competitivewith Treasuries, meaning investors so inclinedcan take advantage of up to 20x leverage.Steeper Curve, Better Roll DownAlthough projected performance can be evaluated inmultiple ways, the most straightforward method is tocompare carry and roll down. In Table 1, we compareTreasury, swap and agency benchmarks across thecurve and evaluate the carry and roll down.The best roll down (we used a 6m time horizon) isclearly in agencies, which benefit from a steepercurve compared to Treasuries and swaps (shown inChart 1). The best sector on the curve for roll down isin the belly - in the 5- to-7y sector for Treasuries andagencies, where the curve is worth 12.4 to 15.1bp,and in the 5y-sector for swaps where 6m roll downpicks up 14.6bp.Competitive Repo, Better CarryCarry was calculated using 6m term repo for bothTreasuries and agencies. In evaluating the Treasurycurve, we used the special term repo for the on-theruns(ranges from a high of 9bp for the 3yT to a lowof -7bp for the 5yT), and general collateral agencyterm repo for the agency bullets (21 bp). Notsurprisingly, the 6m carry in both Treasuries andagencies is uniformly better than in swaps, where thefinancing is effectively 3m Libor – which is about42bp.Yield (%)2.502.252.001.751.501.251.000.750.500.250.00Source: BNP ParibasChart 1: Rates CurvesSwap CurveAgency CurveTreasury Curve0 1 2 3 4 5 6 7 8 9 10Maturity (years)Given the negative repo in the 5yT its carry is bestamong the Treasury group with 13.2bp over 6m. Theflat agency term repo means the carry favours thehighest yielding bonds (since they are mostly on-therunbenchmarks and fairly close to par), making thebest carry in the longest bonds – 14.7bp in the 8yFreddie Mac and 15bp in the 6y Fannie Mae.The final column in the table calculates thecombination of 6m carry + roll down. This shows thatthe agencies offer 21 to 30bp of potential returnversus the 17 to 26bp for Treasuries and 9 to 25bpfor swaps.Be Careful with Projected ReturnsNormally we evaluate agency callables usingprojected returns in Yield Book. For completenessand to provide another basis for comparison, the 6mprojected total return and dollar returns for theTreasuries, agency bullets and swaps are included inthe Table. These projected returns show a slightlydifferent pattern – that Treasuries, not agencies, areexpected to be the best performers. Swaps appear tolag Treasuries rather badly but outperform agenciesin some sectors.Why the difference? This is actually a quirk of YieldBook and emphasises the need to know what theassumptions and methods are when analysingprojected performance data. First, Yield Book doesnot incorporate financing costs (repo), so there is nocalculation of carry. This helps the projectedperformance of the bonds but hurts the performanceof the swaps, which explicitly includes a financingcost. Also, Yield Book does not have an agencycurve, so the bonds have to be priced relative to theswap curve, and the default is to assume that theOAS does not change. Therefore, the actual agencyroll down is underestimated, hurting the relativeperformance.Mary-Beth Fisher 20 October 2011Market Mover22www.GlobalMarkets.bnpparibas.com