Fixed Income Weekly Review & Preview

Transcription

1 Fixed Income Weekly Review & Preview December 8, 2003 Fixed Income Research Joseph W. Jasper, CFA Director, Fixed Income Strategy & Marketing Portfolio Strategy Group Attention will now focus on Tuesday s key FOMC meeting for signs the Fed is unwinding their considerable period language. We maintain that the results of Tuesday s meeting are likely to be a non-event given the still considerable slack in the economy and muted inflation outlook. Further, we expect economic data to be supportive of bond prices during the coming week. HIGHLIGHTS Treasuries Yields fell for a third straight week largely in response to short covering after the release of Friday s weaker-than-expected November employment report. We continue to believe valuations on TIPS will cheapen through year-end. Mortgages While mortgage rates have backed off their recent highs, we continue to favor higher, off-the-run coupon passthroughs as a bet on falling prepays and a higher rate environment. Corporates Spreads narrowed between five and ten basis points last week amid solid investor demand. Improving fundamentals continue to warrant focus on lower-rated, high beta names. Municipals We highlight taxable municipals as an alternative to higher-rated corporates and Treasuries. 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 9 U.S. Bancorp Piper Jaffray

2 YIELD, COMMODITY PRICE, CURRENCY, AND STOCK MARKET CHANGES FOR THE WEEK Last Week Prior Week Change (BP) 3 Month 0.91% 0.93% (2) 2 Year 1.87% 2.05% (18) 5 Year 3.20% 3.36% (16) 10 Year 4.22% 4.33% (11) 30 Year 5.06% 5.13% (7) Curve 2s-10s Curve 2s-30s CRB Crude Oil Gold Yen (1.90) Euro Wilshire Dow Jones Ind. Avg NASDAQ Comp (22.26) Source: Bloomberg Economic Highlights The major event of the week was the weaker-than-expected November employment report. Ironically, while the headline nonfarm payroll data was fairly weak, other indicators continue to point to a broadening recovery within labor markets. Average manufacturing hours worked, hourly earnings, and the unemployment rate all improved for the second straight month. On balance, however, the data do support our view that any improvement in labor conditions will be rather plodding in nature. This in turn is likely to keep the Fed conveniently on the sidelines for at least the next quarter or two. Other data released last week was in stark contract to the employment report, and generally came in stronger than expected. Construction spending Construction spending rose for a fifth month in October, increasing 0.9% over September and reaching the highest ever residential and public building. Commercial investment fell 2.1 percent. Economists had forecast a 0.6 percent rise in October construction spending after a previously reported gain of 1.3 percent for September. ISM nonmanufacturing index The Institute for Supply Management's nonmanufacturing index fell to 60.1 during November, compared with 64.7 in October. This marks the eighth straight month with a reading above 50. While the index has moderated, the ISM nonmanufacturing index is still suggesting expansion in the service sector, which accounts for 85% of GDP. ISM manufacturing index The Institute for Supply Management's manufacturing index rose to 62.8 last month, the highest since December 1983, from 57 in October. November was the fifth straight month of readings higher than 50, indicating expansion. The rise in the headline number was supported by broad-based growth in all the sub-categories. Fixed Income Weekly Review Page 2 of 9 U.S. Bancorp Piper Jaffray

3 Productivity and costs Worker productivity grew at a revised 9.4 percent annual rate in the third quarter, the most in two decades. The Labor Department also released results for unit labor costs, which fell at a 5.8 percent annual rate last quarter, compared to a 3.2 percent drop during Q2. The jump in hours worked (0.8% vs. 2.2%) points to a significant drop in productivity in Q1 to around a more reasonable two to three percent level. Initial claims Initial claims rose to 365,000 last week, well above the consensus increase to 354,000. The four-week moving average of claims, a less-volatile indicator, rose to 362,500 last week from 359,500, which was the lowest since February Meanwhile, continuing claims rose to million from million a week earlier. Looking ahead, the economic calendar is backend loaded, with the only really interesting data points being Thursday s initial claims numbers and Friday s PPI. We have entered a period where weekly claims data is increasingly suspect and prone to considerable revisions. Meanwhile, we expect the November PPI to continue to reflect tame inflationary currents. LAST WEEK S ECONOMIC RELEASES Day Statistic Actual Consensus Estimate Mon. Construction spending 0.9% 0.6% ISM manufacturing index Wed. Non-farm productivity 9.4% 9.2% ISM Non-manufacturing Index Thurs. Initial claims Continuing claims 3,385, Fri. Unemployment rate 5.9% 6.0% Change in non-farm payrolls 57, ,000 Factory orders 2.2% 2.1% Source: Bloomberg THIS WEEK S ECONOMIC RELEASES Day Time Statistic Consensus Previous (CDT) Estimate Tues. 1:15 FOMC rate decision 1.0% 1.0% Thurs. 7:30 Advance retail sales 0.7% -0.3% 7:30 Retail sales Less: autos 0.3% 0.2% 7:30 Business Inventories 0.2% 0.3% 7:30 Initial Claims 355, ,000 7:30 Continuing Claims -- 3,385,000 Fri. 7:30 PPI 0.1% 0.8% 7:30 PPI Less: Food & Energy 0.0% 0.5% 8:50 Univ. of Mich. Confidence Source: Bloomberg Fixed Income Weekly Review Page 3 of 9 U.S. Bancorp Piper Jaffray

4 FIXED INCOME STRATEGY Macro Themes More of the same. We continue to expect rates to trade in their current narrow range through year-end. As a result, we believe the curve will remain fairly steep providing a supportive environment for carry and roll-down strategies. With the long-end likely to continue to be prone to underperformance, we to suggest accounts maintain laddered portfolios to take advantage of the yield curve. Treasuries Treasuries locked in their third straight weekly gain after Friday s release of the November employment report came in much weaker than expected. It is likely, given the sharp immediate response by the market, that traders were positioned very short in anticipation of (1) another improved employment report and (2) the likelihood that the Fed would unwind its considerable period language at Tuesday s FOMC meeting. The ten-year rose 1 1/16 points on the week with its yield declining 11 basis points to 4.21%. The two-year note, which is more sensitive to expectations for Fed policy, rose dramatically with its yield falling back 18 basis points to 1.85%. The Treasury will probably sell nearly $16 billion of five-year notes, and $13 billion of ten-year notes through a reopening of the current 10/13 issue. The curve steepened seven basis points to TIPS We continue to expect breakeven spreads to come under pressure over the next few weeks as inflation expectations are pared, given a Fed on hold. In addition, year-end technicals and new ten-year supply in January will continue to cause breakevens to compress. In light of these factors we would continue to refrain from additional TIPS purchases until breakevens trend down towards sub-two percent levels. GRAPH 1 HISTORICAL TREASURY YIELD CURVE Off-the-runs On-the-runs 1.5 Swap Yields STRIPS Fixed Income Weekly Review Page 4 of 9 U.S. Bancorp Piper Jaffray

5 Source: Bloomberg, U.S.Bancorp Piper Jaffray Mortgages October prepayment rates were reported last week, and as expected some of the biggest declines occurred in 6% and 6.5% coupons. Specifically, one month CRPs fell 21% for both coupons. Likewise, 2003 origination FNCL 5.5%s came in 21% lower, prepaying at 8.8 CPR in November. Given the current steep yield curve and range-bound rate environment, we highlight a swap opportunity out of TBA FNCI 4.5%, and into FNR TG at +82. This bond is a tight window PAC off of 15-year 4.5%s. Yieldbook effective duration on the bond is 4.29 years, which as luck would have it, is very close to the Yieldbook effective duration on the underlying collateral of 4.27 years. While the swap is a yield give up of roughly 25 basis points, swapping out of TBA FNCI 4.5%s and into FNR TG's is one of the rare instances when a significant yield give up swap actually performs well in both a stable and volatile market. GRAPH 2 INCREMENTAL HOLDING PERIOD RETURNS: FNR TG VS. TBA FNCI 4.5% (CONSTANT OAS) 0.80% 0.70% 0.60% 0.50% 0.40% 0.30% 0.20% 0.10% 0.00% -0.10% Parallel Yield Curve Shift (in basis points) Source: U.S. Bancorp Piper Jaffray, Yieldbook 1 Month 3 Months 6 Months 12 Months The base case yield on our FNR TG's, assuming a price is 4.167%, while the underlying collateral at the same prepay assumption is a 4.418% yield ( price for December). Assuming an even par amount swap, this is a yield give up of 25 basis points. We would expect if interest rates remained stable that the PAC would underperform the collateral, and in most cases it would. However, the roll - down effect of the FNR TG's is substantial. Graph 2 depicts the projected return advantage of the FNR TG's relative to FNCI 4.5%s for various investment horizons and parallel yield curve shifts. The "tight window" on the FNR Fixed Income Weekly Review Page 5 of 9 U.S. Bancorp Piper Jaffray

6 03-83 TG's allows it to roll-down the curve more than collateral, generating principal gains that offset the negative carry. Keep in mind that even though the yield curve has flattened over the past month, historically it remains very steep. Admittedly, the performance of this swap is heavily dependent on roll-down, and over shorter holding periods, any significant flattening of the curve works against the swap. However, given our range-bound interest rate outlook, we believe the curve is likely to remain steep well into 04. This scenario plays out well for FNR TG s as its outperformance improves dramatically longer holding periods. For a holding period of one year, for example we project that the yield curve can flatten 50 basis points, and the roll-down of the FNR TG's would still be sufficient to lead to the bond outperforming FNCI 4.5%s. Corporates About $21 billion of bonds in the U.S. last week, keeping up a torrid pace as issuers rushed to close deals before year-end. Demand continues to be solid as generally, better-than-expected Q3 earnings reports continue to support the corporate market. Spreads for the average investment-grade corporate narrowed between five and ten basis points last week, to the lowest levels in nearly five years. As expected, the strongest demand continues to be for lower-rated, higher beta names. As such, we continue to suggest investors steer away from higher-rated paper in favor of lower-rated credits in economically sensitive sectors. We continue to like the autos, telecoms and utilities. Bonds of Ford, for example still over decent value, even after tightening more than 100 basis points after S&P placed the Company on Stable Outlook in November. Municipals Municipal yields responded in a muted fashion to the late rally in Treasuries, which served to maintain the more expensive yield ratios in the front end of the curve. MUNICIPAL CONSENSUS YIELD CHANGES FOR THE WEEK Municipal Change % to Treasury Yield (bp) Last Week Previous Wk 5-Year Avg. 2 Year % 73% 77% 5 Year % 76% 80% 10 Year % 88% 85% 30 Year % 96% 94% Source: Municipal Market Advisors One interesting dynamic within the municipal market is the recent cheapening of taxable insured munis relative to AAA-rated corporates. Graph 2 highlights the fact that while spreads relative to Treasuries have continued to march tighter over the past couple of years, taxable muni spreads relative to high-rated corproates have cheapened dramatically and currently yield as much as +35 basis points more than comparable maturity corporates. We believe investors looking for taxable income among higher-rated issuers should closely examine the opportunities in insured and uninsured taxable municipals. Fixed Income Weekly Review Page 6 of 9 U.S. Bancorp Piper Jaffray

7 GRAPH 2 TAXABLE INSURED MUNI YIELDS VS. TREASURIES AND AAA-RATED CORPORATES Spread (in basis points) /1/00 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 Spread over AAA-Rated Corporates Spread over Treasuries Source: MMA, Bloomberg, U.S.Bancorp Piper Jaffray CORPORATE MARKET DETAIL SELECTED NEW ISSUES FROM LAST WEEK Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P PROCTER & GAMBLE CO /4/2053 NA 30 Aa3 AA- CAMDEN PROPERTY TRUST /15/ Baa2 BBB GENERAL ELEC CAP CORP /5/2007 NA 400 Aaa AAA CIT GROUP INC /15/2010 NA 750 A2 A PRECISION CASTPARTS CORP /15/ Baa3 BBB- VIRGINIA ELECTRIC &POWER /15/ A3 BBB+ VIRGINIA ELECTRIC &POWER /15/ A3 BBB+ TOYOTA MOTOR CREDIT CORP /15/ Aaa AAA COMMERCE GROUP INC /9/ Baa2 BBB MASSMUTUAL GLOB FNDG II /15/ Aa1 AAA HOUSEHOLD FINANCE CORP /15/ A1 A HBOS TREASURY SERVICES /12/ Aa2 AA FAIRMONT HOTELS & RESORT /1/2023 NA 270 NA NA CLEAR CHANNEL COMMUNICAT 5 3/15/ NA NA HANOVER COMPRESSOR CO 0 3/31/2007 NA 263 Caa1 B- SIX FLAGS INC /1/ B2 B- NATIONWIDE BLDG SOCIETY FRN 12/11/2006 NA 700 NA NA NATIONWIDE BLDG SOCIETY /15/ NA NA Fixed Income Weekly Review Page 7 of 9 U.S. Bancorp Piper Jaffray

8 Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P NATIONWIDE BLDG SOCIETY 4 1/15/ NA NA HUNTSMAN LLC /15/ B2 B ALCAN INC /15/2033 NA 750 Baa1 A- ALCAN INC 5.2 1/15/ Baa1 A- ALCAN INC /8/2005 NA 500 Baa1 A- ALCAN INC /8/2004 NA 500 Baa1 A- PETROBRAS INTL FINANCE /10/ Ba2 NA WISCONSIN GAS CO /1/ A1 NA DUKE ENERGY CORP /8/2005 NA 250 Baa1 BBB+ US CELLULAR CORP /15/ Baa1 A- PLAINS ALL AMER PIPELINE /15/ Ba1 /*+ BBB- UNIONBANCAL CORPORATION /16/ A3 BBB+ CONCORD COMMUNICATIONS 3 12/15/2023 NA 75 NA NA ATRIUM COMPANIES INC /1/ B3 B- NORTHERN ILLINOIS GAS /1/ Aa3 AA NORTHERN ILLINOIS GAS /1/ Aa3 AA NORTHERN ILLINOIS GAS /1/ Aa3 AA GENZYME CORP /1/2023 NA 600 NA BBB SWEDISH EXPORT CREDIT /26/ Aa1 AA+ DOMINION RESOURCES INC /15/2023 NA 200 NA NA CONTINENTAL AIRLINES INC /2/2018 NA 415 Ba3 BBB TXU AUSTRALIA HLDINGS /15/ Baa2 BBB RBS CAPITAL TRUST II /15/ A1 A INPUT/OUTPUT INC /15/2008 NA 50 NA NA CROWN CASTLE INTL CORP /1/ B3 CCC INSGHT MIDWST/INSGHT CAP /1/ B2 B+ GEORGIA-PACIFIC CORP 8 1/15/ Ba3 BB+ ASIF GLOBAL FINAN XXV FRN 12/11/2006 NA 500 Aaa AAA 21ST CENTURY INSURANCE /15/ NA BBB+ JP MORGAN CHASE & CO /11/ A1 A+ NIAGARA MOHAWK POWER /1/ Baa2 A NORTHERN TRUST CO /15/ Aa3 AA- RPM INTERNATIONAL INC /15/ Baa3 BBB SWEETHEART CUP CO INC 9.5 1/15/2007 NA 95 Caa1 BBB+ US BANK NA FRN 12/5/2005 NA 2000 Aa2 AA- UNIBANCO-UNIAO DE BANCO /15/ Baa1 NA ISTAR FINANCIAL INC /15/ Ba1 BB+ ISTAR FINANCIAL INC 6 12/15/2010 NA 350 Ba1 BB+ Source: Bloomberg Fixed Income Weekly Review Page 8 of 9 U.S. Bancorp Piper Jaffray

9 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 (USBPJ) was making a market in the Company s securities at the time this research report was published. USBPJ may buy and sell the Company s securities on a principal basis. (^) A USBPJ 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, USBPJ 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. (>) USBPJ 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 USBPJ analyst who follows this Company, a member of the analyst s household, a USBPJ officer, director, or other USBPJ employee is a director and/or officer of the Company. (+) USBPJ 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 USBPJ, 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. USBPJ research analysts receive compensation that is, in part, based on revenues of USBPJ Equity Capital Markets which include investment banking revenues. USBPJ 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 9 of 9 U.S. Bancorp Piper Jaffray