Fixed Income Weekly Review & Preview

Transcription

1 Fixed Income Weekly Review & Preview March 8, 2004 Fixed Income Research Joseph W. Jasper, CFA Director, Fixed Income Strategy & Marketing Private Client Research Treasury yields collapsed last week thanks to an abysmal employment report, the fourth in a row. With employment data seemingly the ultimate arbiter for potential rate hikes, we believe the Fed is now completely out of the picture for 04. We also encourage accounts to maintain duration amid our continued forecast for range bound rates. HIGHLIGHTS Treasuries Treasury prices caught fire after four days of listless trading. Rumors of mortgage convexity buying circulated as five and ten-year maturities led Friday s rally and yields fell 15 and 14 basis points respectively. Ten-year TIPs cheapened 20 basis points immediately after the employment report, but gave it all back by the close. We continue to believe that TIPS are overvalued on a breakeven basis and would look to add only on breakeven spread contractions. Mortgages Premium mortgage paper continues to come under pressure, especially after last week s report on February prepayment rates. We reiterate our call to take profits on premiums and suggest down in coupon trades to maintain mortgage exposure. Agencies Net GSE issuance continues to moderate, providing a supportive environment for agency paper. We continue to favor short-lockout longer-term callables relative to bullets. Corporates Corporate spreads lost modest ground to Treasuries last week, widening by three basis points on average. We continue to recommend overweighting lower-rated investment grade credits. On balance our outlook for corporates remains positive amid continued improvement in corporate credit fundamentals. Municipals Municipal yields fell less than Treasuries, resulting in a much wanted cheapening of munis. We highlight the latest developments in California and suggest a swap out of the recent Cal GO in anticipation of cheaper yields on the upcoming $15 billion deal. We continue to recommend taxable munis, and offer a comparison of the yield pick-up vs. Treasuries, Agencies, and AAA-rated corporates. Piper Jaffray does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decisions. This report should be read in conjunction with important disclosure information, including an attestation under Regulation Analyst Certification, found on the back pages of this report or at the following site: Fixed Income Weekly Review Page 1 of 12 Piper Jaffray

2 YIELD, COMMODITY PRICE, CURRENCY, AND STOCK MARKET CHANGES FOR THE WEEK LAST WEEK PRIOR WEEK CHANGE (BP) 3 Month 0.95% 0.94% 1 2 Year 1.56% 1.65% (9) 5 Year 2.80% 2.95% (15) 10 Year 3.84% 3.98% (14) 30 Year 4.76% 4.85% (9) Curve 2s-10s (7) Curve 2s-30s CRB (0.16) Crude Oil Gold Yen Euro Wilshire ,314 11, Dow Jones Ind. Avg. 10,596 10, NASDAQ Comp. 2,048 2, Source: Bloomberg ECONOMIC HIGHLIGHTS Friday s pathetic employment report disappointed the market for the fourth month in a row, leading to sharp gains in the Treasury market. Nonfarm payrolls rose 21,000 in February, well below the consensus increase. Continued softness was seen in several service-related sectors, while the manufacturing sector lost another 3,000 jobs. This marks the sector s 43 rd monthly decline, albeit the smallest suggesting a somewhat improved outlook for manufacturing payrolls. Consistent with the past two monthly employment reports, the aggregate labor force fell, keeping the unemployment rate at 5.6%, while the labor force fell 392,000. As a result, the labor force participation rate fell to its lowest level since The participation rate (employment/population) ratio fell two tenths to 62.2%, well below the 64.3% when the economy entered the recession in March of The implications are that the economy would have to add close to 300,000 jobs per month for a year just to get back to the 63.0%, the level seen at the trough of the recession. Exacerbating the problem is that productivity remains high, implying significant monthly gains are not likely to accelerate for some time. While other data continue to point towards recovery, we believe the continued, growing slack in the labor market and stagnation in wage growth cast doubts on the robustness of this recovery and therefore the Fed s motivation to raise interest rates anytime soon. To put the current employment picture in perspective, the last time the Fed raised interest rates, in 1999 and 2000, the economy was adding an average of more than 200,000 jobs a month. Against a backdrop of continued benign inflation, high productivity, and slack labor market conditions, we now believe the Fed will remain on hold until sometime in Looking ahead, the economic calendar is relatively quiet, with reports due out on February retail sales, the budget deficit, trade balance, and Michigan consumer sentiment. Perhaps the focal point of the week will be Fed Chairman Greenspan s testimony before the House Education and Workforce Committee on Thursday. Fixed Income Weekly Review Page 2 of 12 Piper Jaffray

3 Appropriately, the topic will be education and job growth. In light of last week s dismal employment report, we would expect the committee s questions to be dominated by concerns about the state of the job market. As such, Greenspan s remarks will be closely watched to see if the Fed s optimism about the economic recovery has faltered. LAST WEEK S ECONOMIC RELEASES DAY STATISTIC ACTUAL CONSENSUS ESTIMATE Mon. Personal Income 0.2% 0.5% Personal Spending 0.4% 0.3% Construction Spending -0.3% 0.2% ISM Manufacturing Weds. ISM Non-Manufacturing Thurs. Non-Farm Productivity 2.6% 2.6% Initial Jobless Claims 345, ,000 Continuing Claims 3,091, Unit Labor Costs -0.4% -1.1% Factory Orders -0.5% -0.5% Fri. Unemployment Rate 5.6% 5.6% Average Hourly Earnings 0.2% 0.2% Change in Nonfarm payrolls 21, ,000 Average Weekly Hours Source: Bloomberg THIS WEEK S ECONOMIC RELEASES DAY TIME STATISTIC CONSENSUS PREVIOUS (CDT) ESTIMATE Weds 7:30 Trade Balance -$41.7B -$42.5B 9:00 Wholesale Inventories 0.4% 0.6% Thurs. 7:30 Import Price Index 0.5% 1.3% 7:30 Advance Retail Sales 0.5% -0.3% 7:30 Less: Autos 0.5% 0.9% 7:30 Initial Jobless Claims 348, ,000 7:30 Continuing Claims -- 3,091,000 Fri. 7:30 Producer Price Index 7:30 Business Inventories :50 U. Michigan Confidence Source: Bloomberg FIXED INCOME STRATEGY Macro Themes Our repeated call for getting out of money market foxholes and extending maturities amid a probable range bound rate environment is paying off handsomely, especially after Friday s economic bomb. In addition, our portfolio call for laddering maturities is also reaping rewards. While our outlook for basically flat line rates amid a Fed on perma-hold is unchanged, we propose trading oriented accounts consider a temporary long-end modification to capture volatility. This trade idea is based on our outlook Fixed Income Weekly Review Page 3 of 12 Piper Jaffray

4 for a bullish flattener of long-dated yields as investors throw in the towel on sitting in cash (see the Treasury section for more details). GRAPH 1 HISTORICAL TREASURY SLOPE Source: Bloomberg, Piper Jaffray Off-the-runs On-the-runs Swap Yields STRIPS Treasuries Spurred by continued weakness in employment, Treasuries rallied hard last week with yields dropping between nine and 15 basis points across the curve. Friday s belly-led rally was significant on a number of accounts as yields fell between 17 and 22 basis points on the day, helping to blow through the lower-end of the market s recent trading range and prompting renewed speculation over mortgage convexity buying. Friday s rally prompted the biggest one-day drop in the five-year yield (22 basis points) since its reopening on September 13, Meanwhile, the 10-year yield plummeted 20 basis points Friday and 15 basis points for the week to 3.84%. The two-year and long bond yields both fell nine basis points to 1.56% and 4.76% respectively. The outperformance of the belly provides some support to the belief that mortgage duration hedging activity was responsible for at least a portion of Friday s powerful move down in yields. Freddie Mac s weekly mortgage rate survey showed that 30-year fixed mortgage rates have fallen to a near seven-month low of 5.59%. In addition, the Mortgage Bankers Association s refi index was at the highest level since August. Traders also dramatically scaled back expectations for a rate hike to well into Q4. Trading in Fed Funds futures as recent as Thursday had been shifting the possibility of a rate hike closer to July, however Friday s employment report reversed those expectations and shifted the odds of a rate hike to November (see Graph 2). Fixed Income Weekly Review Page 4 of 12 Piper Jaffray

5 GRAPH 2 FED FUNDS FUTURES STRIP /4/04 3/5/ Fed Funds Rate (in %) May June July Aug. Sept. Oct. Nov. Source: Bloomberg, Piper Jaffray Looking ahead, the Treasury is scheduled to announce details of its proposed five and ten-year note sales on Monday for auction Wednesday and Thursday. Expectations are for the Treasury to issue $16 billion in five-year and $11 billion in ten-year notes, inline with previous sales. On balance, the curve remains steep. However, Friday s employment report prompted a bullish flattening as investors sought to lock in rates on higher-yielding long-term bonds. At +230 basis points, the difference in yield between two- and tenyear notes still remains at a three standard deviation extreme, although this has narrowed from +260 over the past six months. We continue to expect the curve to remain relatively steep, amid slowly improving economic fundamentals. However, we expect a follow through rally to take hold in long-dated bonds over the next several weeks as investors capitulate and reach for yield. Therefore, trading oriented accounts may want to add exposure to long-dated positions in anticipation of a backend led bullish flattener. We believe the break through to lower yields also suggests the market will again consolidate into another, lower, trading range. Outside of any significant upside jolt, we would expect rates to remain in this new range for the balance of 2004 against a backdrop of continued low inflation and slack labor market conditions. Fixed Income Weekly Review Page 5 of 12 Piper Jaffray

6 GRAPH 3 HISTORICAL TIPS BREAKEVEN YIELDS (5-YR, 10-YR, 30-YR) BE Yield (in %) /1/00 6/1/00 11/1/00 4/1/01 9/1/01 2/1/02 7/1/02 12/1/02 5/1/03 10/1/03 3/1/04 Source: Bloomberg, Piper Jaffray 5-yr BE 10-yr BE 30-yr BE TIPS Friday s employment report, and immediate rally in Treasuries, resulted in a simultaneous narrowing of breakeven spreads. BEs on ten-year TIPS, for example, narrowed a full 20 basis points, before heavy TIPS buying returned BEs to the +240 area by mid-afternoon. We continue to believe that TIPS are overvalued on a breakeven basis (see Graph 1), and believe that TIPS are ripe for a period of underperformance vs. nominals. Still, we acknowledge that periods of overvaluation can exist for extended periods, and the recent surge in oil prices will do nothing to reduce inflation expectations (on a headline CPI basis) over the coming months. Bottom line: we suggest maintaining current TIPS exposure based on their positive performance characteristics in up and down markets, but would wait to add TIPS exposure until BEs cheapen by ten to 20 basis points in the ten and 30-year maturities. Agencies Spreads on agencies tightened vs. Treasuries last week, with the wings of the agency curve outperforming by a couple basis points. Net Agency issuance continues to moderate, falling to $8 billion from January s $22 billion. The implications are a continued supportive environment for agency paper. Specifically, we continue to favor short-lockout, intermediate-term callables and five to ten-year bullets. Both should benefit as the prospects of a Fed rate hike fade and investors extend maturities to capture higher yields. Fixed Income Weekly Review Page 6 of 12 Piper Jaffray

7 Mortgages Mortgages kept pace with Treasuries for the week. As expected, the fall off in rates since the first of the year has prompted a mini-refi boom, resulting in dramatically higher prepays for premium coupon mortgages. We continue to suggest reducing exposure to premiums and suggest expressing mortgage exposure through down-incoupon paper that remains out-of-the-money for refinancing. Refi Index / Mortgage Applications The Mortgage Bankers Association s index of mortgage applications rose 2.8% to The purchase index fell 0.2% to The refinancing index rose 5.1% to Municipals Yields on municipals fell in sympathy with Treasuries, but by a smaller margin, AAA-rated yields declined between ten and 15 basis points, with five and ten-year maturities putting in the best performance. The big story in munis continues to be the developments in California. Voters approved Proposition 57 calling for the issuance of $15 billion in state-backed municipal general obligation bonds. The positive vote prompted both S&P and Moody s to raise their outlooks on the State s municipal debt. Citing the easing of near-term liquidity pressures, Standard & Poor s improved its outlook on California s triple-b general obligation bond rating and triple-b-minus general fund lease obligation to positive, while Moody s Investors Service also changed its outlook to stable from negative. In secondary trading, the recently issued Cal 5 s of 2033 were an offered yield of 4.99% compared to their original yield of 5.07% on February 19. With the lead underwriter already teed up, the new $15 billion offering should come to market in the few weeks creating a potential trading opportunity for those who purchased the February 19 issue. In addition to the $15 billion in new Cal GO supply hitting the market over the next few weeks, voters also approved two other notable Cal deals that, we expect, taken together will cause Cal yields to back up meaningfully, albeit temporarily. Taken alone, the $15 billion offering will be the largest of its kind for the municipal market. However, voters also approved a statewide proposal to sell $12.3 billion in bonds for school construction, and a $3.9 billion Los Angeles Unified School District building improvement issue. Against this flood of new supply, we would encourage trading oriented investors to lock in profits on the February 19 GO deal and wait for cheaper pricing on the upcoming deals. Once the upcoming Cal deals are placed, we would expect to see continued improvement in Cal spreads relative to the consensus AAA scale as outsized yields and improving economic fundamentals attract all manner of muni buyer. Graphs 4 and 5 highlight recent historical yields on Cal 10-year and 30-year GOs vs. Treasuries and the average AAA-rated muni. We reiterate that yields are likely to back up temporarily as the new Cal GO supply hits the market. However, even at current levels, yields on Cal paper make sense for most out-of-state buyers. Our preference would be for 20-year maturities in terms of the best absolute values. Fixed Income Weekly Review Page 7 of 12 Piper Jaffray

8 GRAPH 4 10-YR. CAL GO YIELDS VS. CONSENSUS AAA MUNIS AND TREASURIES Spread (in basis points) /26/03 10/3/03 10/10/03 10/17/03 10/24/03 10/31/03 11/7/03 11/14/03 11/21/03 11/28/03 12/5/03 12/12/03 12/19/03 12/26/03 1/2/04 1/9/04 1/16/04 1/23/04 1/30/04 2/6/04 2/13/04 2/20/04 2/27/04 3/5/ Spread (in basis points) 10-Yr Cal GO vs. Consensus AAA Source: Bloomberg, MMA, Piper Jaffray 10-Yr Cal GO vs. Treas. (right) GRAPH 5 30-YR. CAL GO YIELDS VS. CONSENSUS AAA MUNIS AND TREASURIES Spread (in basis points) /26/03 10/3/03 10/10/03 10/17/03 10/24/03 10/31/03 11/7/03 11/14/03 11/21/03 11/28/03 12/5/03 12/12/03 12/19/03 12/26/03 1/2/04 1/9/04 30-Yr Cal GO vs. Consensus AAA Source: Bloomberg, MMA, Piper Jaffray 1/16/04 1/23/04 1/30/04 2/6/04 2/13/04 2/20/04 2/27/04 3/5/04 30-Yr Cal GO vs. Treas. (right) Another area of interest to us continues to be taxable municipals. Although taxable issuance continues to comprise a small portion of total municipal issuance, there has been a decent increase in taxable issuance associated primarily with state pension Spread (in basis points) Fixed Income Weekly Review Page 8 of 12 Piper Jaffray

9 obligations. We believe taxable munis offer compelling value relative to other taxable alternatives. Consider Graph 6, which highlights the spread on insured 30- year taxable munis vs. AAA-rated corporates and FNMA Sr. bonds. While spreads have come in from their 2003 wides, we believe taxable munis still offer an attractive yield pickup vs. comparably-rated corporate or agency debt. The value proposition is especially obvious relative to AAA-rated corporates, which have become progressively more expensive vs. taxable munis over the past two years. For taxable investors, we believe taxable munis are worth serious consideration and would swap out of high-grade corporates in favor of taxable munis. GRAPH 6 30-YR. TAXABLE MUNI YIELDS VS. AAA-RATED CORPORATES, FNMA SR. DEBT AND TREASURIES Spread (in basis points) /0/00 2/23/01 5/18/01 8/10/01 11/2/01 1/25/02 4/19/02 7/12/02 10/4/02 12/27/02 3/21/03 6/13/03 9/5/03 11/28/03 2/20/04 Spread over Moody's AAA Index Spread over 30-Yr Treasury Spread over 30-Yr FNMA Source: Bloomberg, Moody s, Piper Jaffray MUNICIPAL CONSENSUS YIELD CHANGES FOR THE WEEK MUNICIPAL CHANGE % TO TREASURY YIELD (BP) LAST WEEK PREVIOUS WK 5-YEAR AVG. 2 Year 1.29 (4) 82.7% 80.6% 77.1% 5 Year 2.24 (6) 80.0% 78.0% 80.4% 10 Year 3.33 (6) 86.7% 85.2% 85.4% 30 Year 4.46 (7) 93.7% 93.4% 94.3% Source: Municipal Market Advisors Fixed Income Weekly Review Page 9 of 12 Piper Jaffray

10 CORPORATE MARKET DETAIL CORPORATE RATINGS CHANGES ISSUER MOODY S NEW OLD OUTLOOK NEW OLD OUTLOOK Cargill Inc. -- A1 -- A+ -- Negative Centerpoint Energy Ba2 Ba1 Negative -- BBB- Negative R.R. Donnelley & Sons Co. Baa1 Baa2 Stable A- A Stable PEFCO Finance -- Aaa -- AA AAA Negative Public Service Co. of NM -- Baa3 -- BBB BBB- Stable Avnet Inc. -- Ba2 Stable -- BBB- Negative Southwest Gas Corporation -- Baa2 Negative -- BBB- Stable Universal Corp -- Baa1 Negative -- A- Stable YUM! Brands Baa3 Ba1 Stable -- BB+ Positive Dobson Communications Corp. Caa1 B3 Negative -- CCC+ Negative Hasbro, Inc Baa3 Ba3 Stable -- BB Stable Loews Corp. -- Baa1 Negative -- A -- Tenet Healthcare Corp. B3 B1 Negative -- B+ -- Seacor Smit Inc -- Baa3 Negative -- BBB Positive Deustche Telekom AG Baa2 Baa3 Positive -- BBB+ -- Hospitality Properties Trust -- Baa3 Stable -- BBB- Stable PEPCO Holdings, Inc -- Baa BBB Negative RBC Centura Bank -- Aa A+ Negative S&P SELECTED NEW ISSUES FROM LAST WEEK Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P EVERGREEN RESOURCES INC 6 3/15/2012 NA 200 NA NA CLONDALKIN INDUSTRIES 8 3/15/ B3 B- COVAD COMMUNICATIONS GRP 3 3/15/2024 NA 100 NA NA REPUBLICA ORIENT URUGUAY /20/2006 NA 8193 B3 B- J.B. POINDEXTER & CO /15/ B1 B- STATION CASINOS 6 4/1/ Ba3 BB- NYMAGIC INC 6.5 3/15/ NA NA AVNET INC 2 3/15/2034 NA 300 Ba2 BBB- HARTFORD FINL SVCS GRP /1/ A3 A- ALLSTATE LIFE GLOB FD II NA 4/2/2007 NA 150 Aa2 AA ALLSTATE LIFE GLOB FD II NA 3/15/2006 NA 200 Aa2 AA INCYTE CORP 3.5 2/15/2011 NA 250 NA NA PSS WORLD MEDICAL INC /15/2024 NA 150 NA B OEKB OEST. KONTROLLBANK 2.5 6/15/ NA NA GLOBAL CASH ACC/FINANCE /15/ Caa1 B- DONNELLEY (R.R.) & SONS /1/ Baa1 A- DONNELLEY (R.R.) & SONS /1/ Baa1 A- INTELLISYNC CORP 3 3/1/2009 NA 60 NA NA VISTEON CORP 7 3/10/ Ba1 NA FRIENDLY ICE CREAM CORP /15/ B2 B- WH HOLDINGS/WH CAPITAL 9.5 4/1/ B3 B Fixed Income Weekly Review Page 10 of 12 Piper Jaffray

11 Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P TRUE TEMPER SPORTS INC /15/ B3 B- AIRGAS INC /15/ Ba2 B+ HCA INC /15/ Ba1 BBB- JEFFERIES GROUP INC 5.5 3/15/ Baa2 BBB FIRST HORIZON PHARMACEUT /8/2024 NA 125 NA NA REPUBLIC OF INDONESIA /10/ B2 B BELL MICROPRODUCTS INC /5/2024 NA 110 NA NA ISTAR FINANCIAL INC 5.7 3/1/ Ba1 BB+ JP MORGAN CHASE & CO /15/ NA NA JP MORGAN CHASE & CO 3.5 3/15/ NA NA WASTE MANAGEMENT INC 5 3/15/ Baa3 BBB EOG RESOURCES CANADA /15/ Baa1 BBB+ US BANK NA 3.4 3/1/ Aa2 AA- RAS LAFFAN LIQ NAT GAS /15/ Baa1 A- MASCO CORP /9/2007 NA 300 Baa1 BBB+ AMDOCS LIMITED 0.5 3/15/2024 NA 450 Baa3 BBB- AMERICA MOVIL SA de CV 5.5 3/1/ Baa1 BBB- AMERICA MOVIL SA de CV /1/ Baa1 BBB- MGI PHARMA INC /2/2024 NA 348 NA NA STATION CASINOS 6.5 2/1/ B1 B+ PHELPS DODGE CORP /15/ Baa3 BBB- CARGILL INC /4/ A1 A+ Source: Bloomberg Fixed Income Weekly Review Page 11 of 12 Piper Jaffray

12 Analyst Certification Joseph W. Jasper, CFA The views expressed in this report, including the Key Points and Risk sections in particular, accurately reflect my personal views about the subject Company and the subject security. In addition, no part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in this report. Research Disclosures The following disclosures apply to stocks mentioned in this report if and as indicated: (#) Piper Jaffray was making a market in the Company s securities at the time this research report was published. Piper Jaffray will buy and sell the Company s securities on a principal basis. (^) A Piper Jaffray analyst who follows this Company or a member of the analyst s household has a financial interest (a long equity position) in the Company s securities. (@) Within the past 12 months, Piper Jaffray was a managing underwriter of an offering of, or dealer manager of a tender offer for, the Company s securities or the securities of an affiliate. (>) Piper Jaffray has either received compensation for investment banking services from the Company within the past 12 months or expects to receive or intends to seek compensation within the next three months for investment banking services. (~) A Piper Jaffray analyst who follows this Company, a member of the analyst s household, a Piper Jaffray officer, director, or other Piper Jaffray employee is a director and/or officer of the Company. (+) Piper Jaffray and its affiliates, in aggregate, beneficially own 1% or more of a class of common equity securities of the subject Company. Disclaimer Piper Jaffray research analysts receive compensation that is, in part, based on revenues of Piper Jaffray Equities & Investment Banking which include overall investment banking revenues. Piper Jaffray research analysts who follow this Company report to the Head of Investment Research who, in turn, reports directly to the Chief Executive Officer of Piper Jaffray. This material is based on data obtained from sources we deem to be reliable; it is not guaranteed as to accuracy and does not purport to be complete. This information is not intended to be used as the primary basis of investment decisions. Because of individual client requirements, it should not be construed as advice designed to meet the particular investment needs of any investor. It is not a representation by us or an offer or the solicitation of an offer to sell or buy any security. Further, a security described in this release may not be eligible for solicitation in the states in which the client resides. Officers or employees of affiliates of Piper Jaffray & Co., or members of their families, may have a beneficial interest in the Company's securities and may purchase or sell such positions in the open market or otherwise. Notice to customers in the United Kingdom: This report is a communication made in the United Kingdom by Piper Jaffray & Co. to market counterparties or intermediate customers and is exclusively directed at such persons; it is not directed at private customers and any investment or services to which the communication may relate will not be available to private customers. In the United Kingdom, no persons other than a market counterparty or an intermediate customer should read or rely on any of the information in this communication. Securities products and services offered through Piper Jaffray & Co., member SIPC and NYSE, Inc., a subsidiary of Piper Jaffray Companies. Additional information is available upon request. No part of this report may be reproduced, copied, redistributed or posted without the prior consent of Piper Jaffray & Co Piper Jaffray & Co., 800 Nicollet Mall, Suite 800, Minneapolis, Minnesota Fixed Income Weekly Review Page 12 of 12 Piper Jaffray