Fixed Income Weekly Review & Preview

Transcription

1 Fixed Income Weekly Review & Preview December 19, 2003 Fixed Income Research Joseph W. Jasper, CFA Director, Fixed Income Strategy & Marketing Portfolio Strategy Group Treasuries posted their third straight weekly gains, driven largely off the better than expected CPI report. While other economic reports suggest a broadening recovery is shaping up, we continue to expect rates to remain range bound with the Fed on hold, possibly through Q2, 04. Against this backdrop, we encourage accounts to take advantage of the steep yield curve to capture the roll-down and yield offered in this low rate environment. HIGHLIGHTS Treasuries Treasuries rallied for the third straight week, with intermediate and long-term maturities leading the bullish flattening. While the curve flattened, two s to ten s, to the +230 area, we continue to believe conditions are favorable for a steep curve going into TIPS breakeven yields have fallen sharply over the past two weeks, but we still anticipate better buying opportunities ahead. Agencies The combination of steady short maturity Treasury yields and stable yield spreads create an ideal environment for investors to add incremental return by substituting callables for bullets in the short end of the curve. For investors in longer maturities, the steepness of the yield curve provides substantial roll-down gains for bullets, which leads to an advantage of bullets over callables. Mortgages We believe selected structures in the CMO market offer attractive alternatives to both 15- and 30-year pass-throughs. Corporates Yield spreads tightened modestly vs. Treasuries last week. Municipals Fitch cut the rating on Cal GO s to BBB from A. We continue to believe the situation in California to improve in the months ahead, offering decent value to risk tolerant investors in the meantime. Merry Christmas and happy holidays to all our readers! We are taking a holiday of our own, and will resume publishing the Weekly on January 12 th. U.S. Bancorp 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 11 U.S. Bancorp Piper Jaffray

2 YIELD, COMMODITY PRICE, CURRENCY, AND STOCK MARKET CHANGES FOR THE WEEK Last Week Prior Week Change (BASIS POINTS) 3 Month 0.87% 0.89% (2) 2 Year 1.77% 1.81% (4) 5 Year 3.15% 3.22% (7) 10 Year 4.14% 4.24% (10) 30 Year 4.96% 5.09% (13) Curve 2s-10s (6) Curve 2s-30s (9) CRB (1.57) Crude Oil (0.02) Gold (0.2) Yen Euro Wilshire ,580 10, Dow Jones Ind. Avg. 10,278 10, NASDAQ Comp. 1,951 1,949 2 Source: Bloomberg Economic Highlights Economic reports released last week continued to point to a broadening recovery, especially in the manufacturing sector. Still, we believe the Fed has completely abandoned their historical preference for preemptive tightening. As such, we expect the Fed to continue to foster an environment favorable to reflation. The latest print for the CPI further suggests that inflation, both headline and core, remains a nonevent (see Graph 1), leaving the Fed a considerable period in which to stoke the inflationary coals by simply remaining sidelined. GRAPH 1 MONTHLY CORE CPI (YOY) 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% Jan- 94 Oct- 94 Jul- 95 Apr- 96 Jan- 97 Oct- 97 Jul- 98 Apr- 99 Jan- 00 Oct- 00 Jul- 01 Apr- 02 Jan- 03 Oct- 03 Source: U.S. Bancorp Piper Jaffray Fixed Income Weekly Review Page 2 of 11 U.S. Bancorp Piper Jaffray

3 The Philadelphia Fed index came in at 32.1, far exceeding the 25.0 consensus estimate. December s survey continues to point to a healthy expansion in the Third District s manufacturing sector. The leading indicators index rose 0.3% during November, in line with expectations. The Conference Board cited declining initial unemployment claims and rising consumer expectations as the primary causes for the increase. Initial jobless claims fell more than expected last week, to 353,000, vs. the consensus call of 365,000. Continuing claims were essentially unchanged, at 3.34 million. Industrial production jumped by 0.9% in November, well above consensus expectations. In addition, the gains of the two prior months were revised upwards. Results were very positive, with every sub-sector reporting gains. Meanwhile capacity utilization rose to 75.7% in November, its highest rate in more than a year. Although capacity utilization has begun to rise, it remains well below its historical average (See Graph 2). This is part of the slack the Fed refers to which currently prevents significant inflationary pressures from taxing resources within the industrial segment of the economy. GRAPH 2 MONTHLY CAPACITY UTILIZATION RATE /31/89 5/31/90 9/30/91 1/31/93 5/31/94 9/30/95 1/31/97 5/31/98 9/30/99 1/31/01 5/31/02 9/30/03 Source: U.S. Bancorp Piper Jaffray The CPI declined 0.2% in November, vs. expectations for a slight increase. Core prices fell 0.1%, pushing the rate of core inflation to 1.1% over the last twelve months and below the 38-year low set just two months ago. Chain store sales recovered most of the prior week s losses in the week ending December 13. The ICSC-UBS chain store sales index rose 2.1%. Year-over-year growth improved modestly to 5.1%. Fixed Income Weekly Review Page 3 of 11 U.S. Bancorp Piper Jaffray

4 The NY Empire State Manufacturing Survey reported that conditions remain strong for manufacturers in the state during December as the general business conditions index reached 37.4, well above the consensus estimate of LAST WEEK S ECONOMIC RELEASES Day Statistic Actual Consensus Estimate Mon. Empire Mfg. Survey Tues. CPI -0.2% 0.1% Industrial Production 0.9% 0.4% Thurs. Capacity Utilization 75.7% Initial Claims 353, ,000 Continuing Claims 3,339, LEI 0.3% 0.3% Philadelphia Fed Survey Source: Bloomberg THIS WEEK S ECONOMIC RELEASES Day Time Statistic Consensus Previous (CDT) Estimate Tues. 7:30 Q3 GDP (final) 8.2% 8.2% 7:30 Personal Income 0.4% 0.4% 7:30 Personal Spending 0.7% 0.0% 8:50 Univ. of Mich. Confidence Wed. 7:30 Durable Goods 1.0% 3.4% 7:30 Less: Transportation 1.0% 2.6% 7:30 Initial Claims 355, ,000 7:30 Continuing Claims -- 3,339,000 Source: Bloomberg FIXED INCOME STRATEGY Macro Themes We continue to expect that Treasuries will remain locked in the range of 3.90% to 4.60% which has persisted since late July. Under this scenario, we believe capturing the roll-down offered by the steep yield curve continues to be an attractive way to add incremental return to fixed income portfolios. Treasuries On the week, the curve flattened with the long end outperforming. The two s to ten s spread flattened seven basis points to The two-year yield fell four basis points to close at a yield of 1.77% while the bond shed 13 basis points for a yield of 4.96%. tens and fives followed closely behind the leader with ten s shedding ten basis points for a yield of 4.14% and five s dropping seven basis points to a yield of 3.15%. Fixed Income Weekly Review Page 4 of 11 U.S. Bancorp Piper Jaffray

5 GRAPH 1 HISTORICAL TREASURY SLOPE Off-the-runs On-the-runs 1.5 Swap Yields STRIPS Source: Bloomberg, U.S. Bancorp Piper Jaffray As an indication of just how far inflation expectations have been scaled back recently, note that July Fed Funds Futures suggest that the market has clearly shifted its focus away from a first quarter Fed rate hike to a second quarter rate hike. At their current level of 98.75, which corresponds to a yield of 1.25%, market participants are expecting a 25 basis point rate hike at the June FOMC meeting. TIPS We have been absolutely delighted to finally see breakeven yields on TIPS falling back to more rational levels. The difference between the yields on the ten-year Treasury and the ten-year TIPS narrowed to 2.22% from 2.40% a week ago. On other words, TIPS have dramatically underperformed their nominal counterparts. Breakevens have fallen across the maturity spectrum, and suggests that the scaling back of inflation expectations has taken out some of the inflation premium out of the bonds. We continue to suggest that we would begin adding aggressively to TIPS positions as breakevens approach, the two percent level on ten-year bonds, and subtwo percent levels for the shorter maturities. Fixed Income Weekly Review Page 5 of 11 U.S. Bancorp Piper Jaffray

6 GRAPH 3 TIPS BREAKEVEN INFLATION RATES (BEIRS) /8/03 8/15/03 8/22/03 8/29/03 9/5/03 9/12/03 9/19/03 9/26/03 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 Source: U.S. Bancorp Piper Jaffray Agencies For investors in short maturity callable Agencies, these may indeed be the best of times. As we show in Graph 4 below, yield spreads relative to Treasuries for typical call structures favored by short maturity callable buyers remain steady, and near their widest levels of the year. GRAPH 4 CALLABLE AGENCY SPREADS % 1/10 TIP vs. 6.5% 2/ % 7/13 TIP vs. 4.35% 8/13 12/26/02 1/26/03 2/26/03 3/26/03 4/26/03 5/26/03 6/26/03 7/26/03 8/26/03 9/26/03 10/26/03 11/26/03 2yr. NC 3mo. 2yr. NC 6mo. 3yr. NC 6mo. Source: U.S. Bancorp Piper Jaffray Fixed Income Weekly Review Page 6 of 11 U.S. Bancorp Piper Jaffray

7 Yield spreads on both two-year non-call three-month and two-year non-call sixmonth structures remain near their highest levels for the year, while yield spreads on three year non-call six month structures are near their average spread for the year. Likewise, as shown in Graph 5, yield spreads on longer maturity European callables, while off of the widest levels of the year remain steady and comparatively wide. GRAPH 5 CALLABLE AGENCY SPREADS EUROPEAN CALL /19/02 1/2/03 1/16/03 1/30/03 2/13/03 2/27/03 3/13/03 3/27/03 4/10/03 4/24/03 Source: U.S. Bancorp Piper Jaffray 3-yr NC 1-yr 5-yr NC 2-yr 10-yr NC 3-yr 5/8/03 5/22/03 6/5/03 6/19/03 7/3/03 7/17/03 7/31/03 8/14/03 8/28/03 9/11/03 9/25/03 10/9/03 10/23/03 11/6/03 11/20/03 12/4/03 12/18/03 Over the near term, we suggest that investors consider callable Agencies for maturities inside of four years. The combination of stable short-term yields and relatively wide spreads lead to callables outperforming comparable duration bullet Agency combinations. On the other hand, our analysis finds that for investors in the longer (4+ years) segment of the Agency market, the roll down gains from bullets given the current steep yield curve provide a compelling alternative to callables. Mortgages Yield spreads versus Treasuries on current coupon pass-throughs have been volatile over the past two weeks, but remain near their tightest levels of the year. While we believe fundamental factors such as continued moderation in prepayment rates, and strong demand by both bank and total return investors will continue to support the market, we expect that a continuation of the steep yield curve environment will also lend support to the mortgage market. Given this environment, we believe that selected structures in the CMO market offer attractive alternatives to both 15-year and 30-year pass-throughs. CMOs with tight principal repayment windows are better poised to take advantage of the roll-down opportunities presented by the steep yield curve. As an example, we consider the projected holding period returns offered by a 3.5-year average life accretion directed bond with a nine-month principal Fixed Income Weekly Review Page 7 of 11 U.S. Bancorp Piper Jaffray

8 repayment window, against that of a generic FNMA 15-year 5.0% pass-through. We outline the securities in the table below. Accretion Directed bond vs. TBA FNMA 15 yr. pass-through Action Par Amount Issue Price / Spread Yield to Maturity Effective Duration Buy $10.00MM FNR VL +175/crv 4.382% 3.85 Sell $10.00MM FNCI 5.0% TBA Jan % 3.43 Comparing the yields to maturity of each of the issues in the swap using Bloomberg s median prepayment assumptions, the swap appears to be a give-up in yield of 12.4 basis points. But using Yieldbook s projected prepayments, the swap is an expected give up in yield of only 3 basis points. We display the projected holding period returns for parallel yield curve shifts in Graph 6. GRAPH 6 HOLDING PERIOD RETURNS: FNR 02-55VL VS. FNCI 5.5% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% -0.20% -0.40% Source: Bloomberg, Yield Book, U.S. Bancorp Piper Jaffray Parallel yield curve shift (in bps.) 3 Month horizon 6 Month horizon We can see from the table that even though on the surface the swap out of FNCI 5.0% into FNR VL is a yield give up swap, the projected holding period return grows for longer holding periods. This is mostly attributable to the better roll-down of the FNR VL s relative to the FNCI 5.0%s. As long-term yields remain range bound and mortgage pass-through spreads remain relatively tight, we suggest that investors avail themselves of the opportunities presented by the current steepness of the yield curve. CMO structures with tight principal repayment windows provide an attractive way to capture superior roll down relative to pass-throughs and add incremental total return. Fixed Income Weekly Review Page 8 of 11 U.S. Bancorp Piper Jaffray

9 Refi Index / Mortgage Applications The Mortgage Bankers Association s index of mortgage applications rose 12.6% to The purchase index rose 9.4% to The refinancing index jumped 16.8% to 2, Corporates The Average spread on corporate bonds fell last week to 95 basis points, matching the lowest level since August That level is roughly a third of its high water mark hit last October. On the new issue front, NRG Energy Inc. and BB&T Corp. led companies that sold about $7.5 billion of notes and bonds last week, almost double the amount in the same week a year ago. Strong demand for corporate product spilled over into the secondary market and provided a firm bid to the market as a whole. Just to highlight one of our favorites, the spread on Ford's 7% ten-year notes shed nine basis points on the week to close at +209 basis points over Treasuries. The Company reported last week that its Lincoln division sold more cars in December vs. the same period last year. Municipals Fitch Ratings Service lowered the rating for California s general obligation bonds three levels to BBB from A. The ratings action is consistent with S&P and Moody s recent actions, although Fitch said the state's rating remains on a negative watch, meaning another downgrade is possible. Bids on 30-year California indicated a yield of 5.18%, roughly 59 basis points more than AAA-rated municipal debt, and about 5 basis points wider on the week. We continue to believe that, although spreads may continue to drift modestly wider in coming weeks, Cal bonds offer considerable value for risk tolerant accounts. We site the broadening economic recovery and likely legislative resolution to California s budget woes in support of our argument. MUNICIPAL CONSENSUS YIELD CHANGES FOR THE WEEK Municipal Change % to Treasury Yield (basis Last Week Previous Wk 5-Year Avg. points) 2 Year 1.38 (5) 78.0% 79.0% 77.1% 5 Year 2.39 (6) 75.9% 76.1% 80.4% 10 Year 3.53 (9) 85.3% 85.4% 85.4% 30 Year 4.70 (8) 94.8% 93.9% 94.3% Source: Municipal Market Advisors CORPORATE MARKET DETAIL SELECTED NEW ISSUES FROM LAST WEEK Issuer Coupon Maturity Spread Amt. Rating (basis (MM) Moody S&P points) s HYUNDAI MOTOR MFG ALABAM /19/ Ba1 BB+ BERKSHIRE HATHAWAY FIN /15/ Aaa AAA ADAPTEC INC /22/2023 NA 225 NA B- Fixed Income Weekly Review Page 9 of 11 U.S. Bancorp Piper Jaffray

10 Issuer Coupon Maturity Spread Amt. Rating (basis (MM) Moody S&P points) s L-3 COMMUNICATIONS CORP /15/ Ba3 BB- BB&T CORPORATION /23/ A2 A- MDU RESOURCES GROUP INC /15/ A2 A- EL POLLO LOCO INC /15/2009 NA 110 B2 B EXELON GENERATION CO LLC /15/ Baa1 A- PRICOA GLOBAL FUNDING /22/2006 NA 250 A1 A+ CSN ISLANDS VIII CORP /16/ B1 B+ PIEDMONT NATURAL GAS CO 6 12/19/ A3 A PIEDMONT NATURAL GAS CO 5 12/19/ A3 A OAKMONT ASSET TRUST /22/ Baa3 BBB DOLLAR DIVERS RIGHT FIN /16/2013 NA 250 Baa1 BBB NRG ENERGY INC 8 12/15/ B2 B+ RESOLUTION PERFORM PROD 8 12/15/2009 NA 140 B2 B+ REGION OF SICILY /22/2016 NA Aa2 AA SOC CONC AUTO CENTRAL /15/ Aaa AAA FLEETWOOD ENTERPRISES 5 12/15/2023 NA 80 NA NA MENTOR CORP /1/2024 NA 125 NA NA TELENET COMMUNICATION NV 9 12/15/ B3 B- TELENET GROUP HOLDING NV 0 6/15/ Caa2 CCC+ AGCO CORP /31/2033 NA 175 NA BB- /*- HUNTINGTON NATIONAL BANK 4.9 1/15/ NA NA SUBURBAN PROPANE PARTNRS /15/ B1 B ASBURY AUTMOTIVE GROUP 8 3/15/ B3 B OVERSEAS PRIVATE INVEST 0 5/27/2008 NA 73 NA NA NEXSTAR FINANCE INC 7 1/15/ B3 B- KROLL INC /15/2014 NA 175 B2 B Source: Bloomberg Fixed Income Weekly Review Page 10 of 11 U.S. Bancorp Piper Jaffray

11 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 its fixed income securities. 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 fixed income securities mentioned in this report if and as indicated: (#) U.S. Bancorp Piper Jaffray (USBASIS POINTSJ) was making a market in the Company s securities at the time this research report was published. USBASIS POINTSJ may buy and sell the Company s securities on a principal basis. (^) A USBASIS POINTSJ 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, USBASIS POINTSJ 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. (>) USBASIS POINTSJ 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 USBASIS POINTSJ analyst who follows this Company, a member of the analyst s household, a USBASIS POINTSJ officer, director, or other USBASIS POINTSJ employee is a director and/or officer of the Company. (+) USBASIS POINTSJ and its affiliates, in aggregate, beneficially own 1% or more of a class of common equity securities of the subject Company. (=) One or more affiliates of U.S. Bancorp, the ultimate parent company of USBASIS POINTSJ, provided commercial banking services (including, without limitation, loans) to the Company at the time this research report was published Disclaimer Nondeposit investment products are not insured by the FDIC, are not deposits or other obligations of or guaranteed by U.S. Bank National Association or its affiliates, and involve investment risks, including possible loss of the principal amount invested. USBASIS POINTSJ research analysts receive compensation that is, in part, based on revenues of USBASIS POINTSJ Equity Capital Markets which include investment banking revenues. USBASIS POINTSJ research analysts who follow this Company report to the Head of Equity Research who, in turn, reports only to the Head of Equity Capital Markets. 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. Affiliates of U.S. Bancorp Piper Jaffray, including U.S. Bancorp and their respective officers or employees, 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 U.S. Bancorp Piper Jaffray 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 U.S. Bancorp Piper Jaffray, member SIPC and NYSE, Inc., a subsidiary of U.S. Bancorp. Additional information is available upon request U.S. Bancorp Piper Jaffray, 800 Nicollet Mall, Suite 800, Minneapolis, Minnesota Fixed Income Weekly Review Page 11 of 11 U.S. Bancorp Piper Jaffray