Research. Quarterly. Bond Market Issuance Higher in the Second Quarter; Lower for the First Half of the Year

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1 Research Quarterly Bond Market Issuance Higher in the Second Quarter; Lower for the First Half of the Year Issuance in the fixed-income markets increased 1.6 percent in the second quarter to $1.36 trillion compared to $1.34 trillion in the first quarter. Total volume for the first half of the year was $.7 trillion, down from $.93 trillion issued in the first half of last year. There was strong growth in the asset-backed and municipal markets, with both sectors on a record issuance pace. The ABS market growth was driven by the home equity loan sector, as housing continued to prosper. Municipal issuance gains were led by refunding volume growth. The year-over-year decline in total issuance is attributable to housing-related securities, including agency MBS and straight agency debt, as the agencies implement new capital management strategies and refinancings fell from previous periods. There were also declines in corporate issuance, as credit spreads widened before recovering late in the quarter, and Treasury issuance, as the federal budget deficit narrowed during the current fiscal year. As we enter the second half of the year, solid and sustained economic expansion and rising interest rates characterize the market environment. Rates at the short end of the curve should continue to rise as the Fed implements its measured policy, and increases in rates at the longer end are being constrained by reduced inflationary expectations, Federal Reserve credibility and investor demand. All of this suggests a continued flat yield curve and higher rates from historically low levels. Under this scenario, there will be fewer refinancing opportunities and issuance growth will be increasingly dependent on new money financing. Generally favorable credit quality conditions should hold for the balance of the year. Highlights Treasury gross coupon issuance totaled $413.5 billion in the first half of the year, down from $47. billion one year ago. Federal agencies long-term debt issuance fell 41.1 percent to $347.7 billion in the first six months. Total long-term municipal issuance increased to $1.4 billion for the year, up 1.8 percent. New corporate bond issuance decreased to $34.8 billion in the first half, a 6.9 percent decrease from one year ago. Asset-backed securities issuance increased 35.5 percent, to a semiannual record of $555.6 billion. Volume in the mortgage-related securities market decreased 11.7 percent to $836.5 billion, compared to the $946.9 billion issued one year ago. The outstanding volume of money market instruments totaled an estimated $3.15 trillion at the end of June. Special Report: U.S. and European Bond Issuance Issuance in the U.S. Bond Markets 4:Q YTD vs. 5:Q YTD 4:Q 5:Q Mortgage- Related Federal Corporate (1) Treasury (1) Agency (1) (1) Includes long-term issuance only Outstanding Bond Market Debt As of June 3, 5* Corporate $5. T Treasury (1) $4. T 1.9% 16.4%.6% Money Market $3. T Total: $4.5 Trillion () 1.9% 7.6% (1) Includes marketable public debt () Figures may not add due to rounding * The Bond Market Association estimates Asset-Backed $1.9 T Asset- Backed Federal Agency $.7 T 8.7%.9% Michael Decker, Senior Vice President Research and Policy Analysis Steven Davidson, Vice President and Director of Research Marcelo Vieira, Manager, Market Statistics Tiffany Coln, Research Analyst Bryan Gross, Research Analyst Sylwia kolankowska, Analyst Municipal (1) Municipal $.1 T Mortgage- Related $5.6 T Headquarters: Madison Avenue, New York, NY Washington Office: New York Avenue, NW, Washington, DC European Office: St. Michael s House, 1 George Yard, London EC3V 9DH 5 Sources: Thomson Financial Sec., U.S. Treas., U.S. Federal Agencies, Inside MBS & ABS Sources: Federal Reserve System, U.S. Treasury, GNMA, FNMA, FHLMC, Bloomberg

2 Treasury Market Treasury Issuance Lower Due to Seasonal Factors and Reduced Budget Deficit Gross coupon issuance of U.S. Treasury securities was $413.5 billion in the first half of the year, a 3. percent decline from the $47. billion issued in the same period of 4. Second quarter gross coupon issuance totaled $4.7 billion, a 1.9 percent decline from the $8.8 billion issued in the first quarter. Higher-than-expected corporate and individual tax receipts, strong economic growth and a declining federal budget are contributing factors in the downward trend of Treasury borrowing levels. In addition, the second quarter is usually the lowest issuance quarter of the year as tax revenues peak around April 15, lowering the Treasury s demand for cash. Net issuance of both bills and coupons totaled $65.6 billion in the first half of 5, compared to $177.1 billion a year ago, a result of the lower budget deficit this year. Total marketable Treasury debt outstanding reached $4.1 trillion as of June 3, 5, a 1.8 percent decline from the $4.9 trillion outstanding at the end of March. The White House Office of Management and Budget projects a budget deficit of $333 billion in fiscal year 5, down from its original projection of $47 billion and the FY 4 deficit of $41 billion. This reflects the influence of a growing economy. The structural deficit, however, remains a challenge. Daily trading volume of Treasury securities by primary dealers averaged $568. billion in the first half of 5, up 13.4 percent from the $51.3 billion average over the same period a year ago. Demand for Treasury securities continues to be strong, influenced by global monetary policy and economic conditions. China s revaluation of the yuan in late July highlights the growing interdependence of global economies. The revaluation, though, is not expected to have a significant effect on Treasury yields and purchasing trends. Average daily trading volume of Treasury Inflation Protected Securities (TIPS) reached $8.9 billion, up from the daily average of $4.8 billion in the first half of 4, which reflects the expanded issuance and introduction of the 5-year and -year TIPS programs. Outlook The Department of the Treasury projects it will borrow a net $59 billion in the third quarter, lower than the $89 billion borrowed in the previous year. The lower year-over-year volume expectation is based on the lower deficit levels this year. It should be noted that the Treasury announced in early August that it is re-introducing the 3-year bond. The Federal Reserve continues its measured course in its efforts to bring monetary policy towards neutral. The FOMC has raised the target Fed funds rate through ten quarter-percentage-point increases since June of 4. During the second quarter, the Treasury yield curve flattened further, which is to be expected in a period of tightening monetary policy, with 1-year Treasury yields dropping to 3.91 percent at the end of the second quarter and the -year to 1-year yield spread at 8 basis points. On August 1, the 1-year was at 4.31 percent. According to The Bond Market Association survey, Treasury yields are expected to rise at a moderate pace through year-end and the yield curve will continue to flatten. 8 % Yield The Bond Market Association Research Quarterly Treasury Yields and Fed Fund Rate Jan Jun. 5 1/98 1/99 1/ Treasury Mortgage-Related Issuance of U.S. Treasury Securities (1) :Q -yr Tsy 1-yr Tsy Fed Funds Target 1/1 U.S. Treasury Securities Outstanding* vs. Mortgage-Related Securities Outstanding** 1 1/ 1/3 3 * Includes Marketable Public Debt ** Includes Agency MBS, Agency CMO and Private-Label MBS Average Daily Trading Volume of U.S. Treasury Securities * :Q1 5:Q Q1 1/4 4 1/5 6/5 5:Q Q Q3 Q4 Q1 Q Q3 Q4 Q1 Q Q3 Q4 Q1 Q * Primary dealer activity 1 (1) Includes only marketable coupon securities Source: U.S. Treasury Sources: U.S. Treasury, Federal Agencies, The Bond Market Association Source: Federal Reserve Bank of New York

3 Federal Agency Market Federal Agency Issuance Declines Long-term debt issuance by federal agencies totaled $347.7 billion in the first half of the year, substantially less than the $589.9 billion issued during the first half of 4. The second quarter volume of $159.5 billion was 15.3 percent lower than issuance in the first quarter of this year and the lowest since the third quarter of last year. While the Tennessee Valley Authority (TVA) posted a substantial increase as a result of two large global bond deals this year, issuance for the other federal agencies fell an average of 4 percent during the first half of the year compared to 4. The Federal Home Loan Banks (FHLB), Fannie Mae and Freddie Mac accounted for most of the decrease, as the agencies continue to adjust their portfolio strategies. The Bond Market Association s recent quarterly survey of agency issuance predicted gross issuance to total $153 billion in the third quarter, down only slightly from the $156 billion issued in the second quarter. The modest decline suggests that the issuance volumes may be stabilizing. The projected agency issuance decrease for the coming quarter reflects the effect of rising interest rates, which would affect mortgage originations, and the continued implementation of new capital and balance sheet strategies Long-Term Federal Agency Debt Issuance (1) :Q (1) Excludes maturities of one year or less 14 Basis Points U.S. Agency Spreads to U.S. Treasury 1-Year :Q Source: Federal Agencies Long-Term Federal Agency Debt Issuance 4 4:Q YTD 5:Q YTD % Change YTD $ Change YTD FHLB % (84.1) 6 4 1/98 1/99 1/ 1/1 1/ 1/3 1/4 1/5 6/5 Freddie Mac % (66.) Fannie Mae % (86.3) Sallie Mae % (6.5) FCS % (.6) Total Federal Agency Debt Outstanding As of June 3, 5 FHLB 3 $98. 33% 3% 4% Sallie Mae $79.7 FCS 1 $14.8 1% TVA $3. TVA % 1.5 Totals % (4.) Short-Term Federal Agency Debt Outstanding 6/3/4 3/31/5 6/3/5 % Change* $ Change* FHLB % 39.7 Freddie Mac % 11.6 Fannie Mae % (64.7) Sallie Mae % (.8) FCS % 1.7 TVA %.6 Totals % (11.9) * Percentage and $ amount change between 3/31/5 and 6/3/5 1 Federal Home Loan Bank System Farm Credit System 3 Tennessee Valley Authority Freddie Mac $ % 31% Fannie Mae $ Farm Credit System Tennessee Valley Authority 3 Federal Home Loan Bank System Total: $,73.5 Billion Average Daily Trading Volume of Federal Agency Securities (1) :Q Coupons Discount Notes * (1) Primary dealer activity *First year in which specified maturity levels were reported 4 5 Source: Federal Agencies Source: Federal Reserve Bank of N.Y. The Bond Market Association Research Quarterly 3

4 Municipal Market Refunding Leads Municipal Issuance Growth in Low-Interest-Rate Environment Total short- and long-term municipal securities issuance reached $8.7 billion in the first half of 5, up 7.3 percent compared to the $13. billion in the same period of 4. A surge in refunding volume led the increase. With a flattening yield curve, and relatively low long-term rates, municipal borrowers continue to find opportunities to reduce borrowing costs by refinancing or refunding existing and more expensive debt. Long-term municipal volume was on a record pace during the first half of 5, reaching $1.4 billion, 1.8 percent higher than the $19. billion issued in the first half of 4. Long-term issuance also grew at a solid pace during the second quarter, peaking at $43.9 billion in June. Municipal issuers, as well as investors, continue to be attracted by the current environment of relatively low long-term rates and a flattening yield curve. The ratio of the 1-year AAA-rated general obligation municipal yield to Treasury securities of similar maturity increased to 9 percent in the second quarter. The relatively high ratio suggests that, even if the consensus proves to be correct and Treasury yields increase, the effect on municipal bond prices and yields will be more muted. New Capital Volume Falls Slightly New capital issues totaled $113.8 billion in the first two quarters of 5, down 5.8 percent from the $1.8 billion issued in the same period of 4. The new money issuance trend reflects a lessened need to borrow as the fiscal positions of state and local governments strengthen. Education sector issues ranked first in use-of-proceeds, with $35.8 billion issued, followed by the general purpose and healthcare sectors. Issuance in the general purpose category fell 43 percent, to $5.7 billion in the first half of the year to rank second among use-of-proceeds sectors. Transportation related new capital issues also increased, rising 33.5 percent to $1.3 billion. Refunding Volume Surges, Drives Record Pace Refunding volume drove the overall issuance growth. Municipal issuers were able to capitalize on opportunities to lower borrowing costs through refunding outstanding debt as long rates remained low based on controlled inflation, market confidence of Federal Reserve policy and investor demand for fixed-income securities. Refunding volume totaled $96.7 billion in the first half of 5, up nearly 4 percent compared to the $69. billion issued in the first half of 4. Among use of proceeds sectors, education-related issues topped the list with $3.4 billion issued, nearly doubling issuance volume over the $16.3 billion issued in the same period of 4. General purpose-related borrowing followed with $9.7 billion, a 34.3 percent increase over the first half of 4. Healthcare and housing related issues declined 7.3 and 19.9 percent, respectively. The rise in yields since quarter-end is likely to slow refunding volumes during the second half of the year Short- and Long-Term Municipal Issuance :Q 1. % (1) Includes maturities of 13 months or less Short-Term (1) 3 4 Municipal GO AAA and 1-Yr Treasury Ratio :Q 1/98 1/99 General Gov t 1/ Education 1/1 Transportation 1/ Healthcare 1/3 Long-Term 1/4 Housing 4 5 1/5 5/5 Municipal Refunding: Use of Proceeds 4:Q YTD vs. 5:Q YTD 4:Q 5:Q Average Daily Trading Volume of Municipal Securities * :Q1 5:Q 18 Utilities :Q1 :Q :Q3 :Q4 3:Q1 3:Q 3:Q3 3:Q4 4:Q1 4:Q 4:Q3 4:Q4 5:Q1 5:Q * Includes both dealer-to-dealer and dealer-to-customer transactions Source: Thomson Financial Securities Data Source: Thomson Financial Securities Data Source: Municipal Securities Rulemaking Board The Bond Market Association Research Quarterly 4

5 Corporate Bond Market Corporate Bond Issuance Lower in First Half; Credit Spreads Recover Late in Q Corporate bond issuance declined to $34.8 billion in the first half of the year, 6.9 percent lower than the $366.1 billion issued a year ago. Second quarter issuance slipped by 1.4 percent, to $15. billion on a linked-quarter basis but was 8.8 percent above the $137.9 billion issued in the second quarter of 4. The lower issuance levels reflect the less sanguine market conditions during much of the first half of the year, compared to last year s market sweet spot of low benchmark yields, tightening spreads and improving credit quality. The 4 volume was also boosted by a very strong first quarter. Coincident with the Ford and GM downgrades, corporate spreads began widening in the latter part of the first quarter and continued into the second. The wider spreads were indicative of the higher risk premium demanded by investors at that time. More recently, the sector has shown its resilience, as credit spreads tightened and recovered much of the lost ground. With benchmark rates having risen over the last month, the issuance environment is likely to be challenging, though funding costs still remain historically low. Despite the recent market sector gains, spreads can still widen especially as benchmark yields rise, which would have the effect of increasing corporate bond financing costs and constraining issuance. Considering the ample corporate cash positions, issuance supply growth will be dependent on such factors as capital spending and M&A and LBO activity. During the first half of the year, business capital investment grew, but at a more moderate pace than the double digit percentage growth last year. As a J.P. Morgan credit research report noted, M&A monthly volume through the first five months of the year exceeded the average 4 levels, but by generally modest margins, though a number of large deals have been recently announced. Credit Quality Remains Solid Despite Recent Weakening After an extended period of favorable conditions, credit quality showed some signs of weakening. Corporate credit quality continues to be solid. Standard and Poor s Global Fixed Income Research notes that, while global downgrades exceeded upgrades in Q for the first time in four quarters, the upgrade to downgrade relationship remains about the same as a year ago, though the U.S. ratio slipped on increased downgrade volume. S&P also notes the distribution of rating outlooks (and CreditWatch implications) trending towards stability with some reduction in negative rating views compared to last quarter and a year ago. There are cautionary signs on the horizon with respect to sector credit exposure. Each of the three major rating agencies S&P, Moody s and Fitch cite historically low high yield or speculative grade default rates in the 1 to percent range, with expectations that the default rates will remain at roughly those levels for the balance of the year but could increase as we enter 6. In recent weeks, corporate bond spreads to comparable Treasuries have once again tightened after the March to May widening period, supporting the corporate credit sector resiliency thesis. As reported by Stone McCarthy Research Associates, the Merrill Lynch Index investment Corporate Bond Issuance (1) :Q '98 '99 ' '1 High-Yield Investment-Grade Avg. Deal Size 3 $ Millions ' '3 '4 15 (1) Includes all non-convertible corporate debt, MTNs, and Yankee bonds, but excludes all issues with maturities of one year or less, CDs and federal agency debt. Source: Thomson Financial Securities Data U.S. Corporate Spreads to U.S. Treasury 1-Year :Q 5 Basis Points 1/ /99 1/ 1/1 1/ 1/3 '4 1/4 ' BBB+ AAA Corporate Debt Outstanding Financial Sectors* As of June 3, 5* Funding Corporations Commercial Banking 5% Total: $1,895.4 Billion 17% 43% * The Bond Market Association estimates 11% REITs Brokers and Dealers 4% Savings Institutions % Finance Companies 1/5 6/5 Average Daily Trading Volume for Corporate Bonds (1) :Q1 5:Q :Q1 :Q :Q3 :Q4 3:Q1 3:Q 3:Q3 3:Q4 4:Q1 4:Q 4:Q3 4:Q4 5:Q1 5:Q (1) Primary dealer activity; excludes all issues with maturities of one year or less Sources: Federal Reserve System, The Bond Market Association Source: Federal Reserve Bank of New York The Bond Market Association Research Quarterly 5

6 Corporate Bond Market continued from page 5 grade and high-yield sector spreads tightened five consecutive weeks through the end of July. As of July 8, according to the Merrill Lynch Index data, the investment-grade spread stood at about 88 basis points compared to 95.5 basis points on June 3 and 95 basis points at the end of 4. High-yield or speculative grade spreads were at about 333 basis points, compared to 384 basis points on June 3 and 31 basis points at year-end 4. The credit default swap spreads have moved in a similar direction, having begun to tighten before the cash market. Small Year-Over-Year Decrease in Investment Grade Issuance Investment-grade non-convertible debt issuance declined slightly through the first six months, to $31.3 billion, a.1 percent decline from a year ago. On a linked-quarter basis, issuance declined.5 percent, to $133.4 billion. Issuance volume, however, increased 16.9 percent from 4 levels. The financial services industry including investment banks, commercial banks and credit institutions dominated issuance activity in the second quarter, totaling $73.6 billion, or 55. percent of total issuance. For the year, financial sector issuance accounted for 61.8 percent of the corporate totals, compared to 6.5 percent a year ago, reflective of both sector growth and industry consolidation. High-Yield Issuance Slows New issue volume of non-convertible high-yield debt totaled $39.5 billion through the first six months, a 3.1 percent decline from $58. billion in 4. On a linked-quarter basis, issuance fell 8.3 percent, to $16.5 billion, down from $3. billion in the first quarter. The manufacturing sector led the way at $11.1 billion in the first six months but was 31.5 percent lower than the issuance volume of a year ago. MTN and Convertible Debt Slows Issuance of Medium-Term Notes (MTN) declined to $111. billion in the first six months of 5, down.3 percent from $14.8 billion issued at the same time a year ago. On a linked-quarter basis, issuance fell 33.3 percent, to $44.4 billion, down from $66.6 billion in the first quarter. Reflecting the volatile rate environment for much of the second quarter and equity market conditions, convertible bond issuance (including investment-grade and high-yield issues) totaled $4.4 billion, a 14.8 percent decline from the first quarter and 46.6 percent from a year ago. Issuance in the first half of the year totaled $9.6 billion, down from $1. billion in 4. Trading Volume Lower The average daily corporate trading volume by primary dealers for bonds with maturities of greater than one year decreased 9.1 percent in the second quarter, to $.9 billion, down from $3. billion during the first quarter of 5. According to MarketAxess, and based on information disseminated through the NASD s TRACE system, total estimated investment-grade average daily trading volume in the second quarter was $9.7 billion, down 13.4 percent from the first quarter. High-yield average daily trading volume increased to $5.5 billion. 6. % Yield U.S. Corporate: AAA Industrial Yield Curves 9.5 % Yield Years to Maturity 1 6/3/5 3/31/5 6/3/4 U.S. Corporate: BB Industrial Yield Curves /1 4/1 4/8 4/15 4/ 3 4/9 5 7 Years to Maturity 5/6 5/13 5/ 5/7 1 6/3/5 3/31/5 6/3/4 TRACE Investment-Grade Daily Trading Volume 5:Q TRACE High-Yield Daily Trading Volume 5:Q 4/8 4/15 4/ 4/9 5/6 5/13 5/ 5/7 6/6 6/6 6/13 6/13 6/ 6/ 3 3 6/8 6/8 Source: MarketAxess Source: MarketAxess The Bond Market Association Research Quarterly 6

7 Asset-Backed Market ABS Market Continues to Expand at Rapid Rate The torrid pace of new issue activity in the asset-backed securities (ABS) market continued in the first half of the year, and it is on pace to surpass the $1 trillion mark by the end of the year. The strong housing market, new product development, low interest rates and robust investor demand have led to a semiannual issuance record of $555.6 billion, up 35.5 percent from the $41. billion issued in the first half of 4. Activity in the second quarter totaled $3.1 billion, up 19. percent from the $53.5 billion issued in the first quarter and nearly 4 percent higher than the second quarter of 4. The home equity loan (HEL) sector, which accounted for nearly 4 percent of total issuance, continued to lead the way. Since the beginning of 4, there has been a shift in ABS coupon structures. The floating rate structure typical of ABS issuance in a steep yield curve environment has declined compared to securities paying a fixed-rate coupon, as the curve has flattened. Floating-rate coupons accounted for 4 percent, or $17.5 billion, of all ABS issued in the first half of 4, but only $116.8 billion, or 1 percent, of all ABS issued during the first half of this year. As rates move up, we could see a reversion for floating rate structures. Despite slightly higher interest rates in the beginning of the third quarter, the drivers are still in place for a strong second half: a resilient housing market, with home sales at record levels; interest rates remaining near historic lows, even taking into account the recent run-up in yields and a growing economy. Retail sales increased 1.7 percent in June, which should bode well for consumer related sectors in the third quarter. Leading ABS Sectors Issuance in the HEL sector increased 7.8 percent in the first half of the year, to $5.8 billion, compared to the $19.9 billion issued during the same time last year. The sector continues to benefit from a record breaking housing boom. Housing sales in the first half of 5 increased 7. percent from the record set last year. The auto loan sector increased 34.6 percent in the first half of the year, to $49.9 billion, compared to the $37.1 billion issued during the same period last year. Auto sales continued to be robust in the second quarter, as car manufacturers provided buying incentives, generating a high level of supply for securitization. As we predicted last quarter, issuance in the sector was boosted by the downgrades of GM and Ford corporate bonds, which made the ABS market an increasingly attractive source of financing. New issue activity in the credit card sector totaled $1.6 billion, down from the $5.7 billion issued in the first half of 4. The use of HEL to consolidate consumer debt is a factor in credit card ABS issuance trends. Industry consolidation is also likely to affect volumes in the coming quarters. Issuance in the student loan sector totaled $8.7 billion in the first half of the year, up from the $6. billion issued last year during the same time. Volume was especially strong in the second quarter, totaling $16.1 billion, up 8.4 percent from the first quarter of the year and up 1.5 percent from the second quarter of 4. The market continued to benefit from the need to finance higher education as higher education expenses rise Issuance of Asset-Backed Securities :Q Public 1 Basis Point 6/4 7/4 8/ Asset-Backed Spreads to U.S. Treasuries June 4 June 5-1 6/4 7/4 8/4 4 Private 5 3-Year Home Equity 3-Year Credit Card -Year Prime Auto Sources: Thomson Financial, Inside MBS & ABS Source: J.P. Morgan Securities Inc. 9/4 1/4 11/4 1/4 1/5 /5 3/5 4/5 5/5 6/5 Asset-Backed Swap Spreads June 4 June 5 3-Year Home Equity 3-Year Credit Card -Year Prime Auto Source: J.P. Morgan Securities Inc. 9/4 1/4 11/4 1/4 1/5 /5 3/5 4/5 5/5 6/5 ABS Outstanding by Major Types of Credit As of June 3, 5 Home Equity $476. B Manufactured Housing $35. B Equipment Leases $64.3 B Total: $1,859.5 Billion 1.9% 3.5% 5.5% 7.1% 19.6% 15.5% Credit Card Receivables 365. B Student Loans 1.% 14.7% $131.1 B Other $7.9 B Automobile Loans $7.4 B CDO $87.4 B Sources: Federal Reserve System, The Bond Market Association The Bond Market Association Research Quarterly 7

8 Mortgage-Backed Market Mortgage-Related Securities Issuance Increases in Q; Still Down for the Year Mortgage-related securities issuance, which includes agency and nonagency pass-throughs and CMOs, increased 5.7 percent in the second quarter, to $49.9 billion, compared to the $46.6 billion issued in the first quarter. Despite the second quarter gain, the issuance of $836.5 billion during the first half of the year was 11.7 percent lower than the $946.9 billion during the same period a year ago. The second quarter increase was driven by lower mortgage rates early in the quarter, which generated higher new home purchase and refinancing origination volumes. According to the Mortgage Bankers Association, mortgage originations increased to an estimated $779 billion in the second quarter, up from the $597 billion in the first quarter. Refinancing increased from $75 billion in the first quarter to an estimated $31 billion in the second quarter. Despite the higher agency mortgage-backed securities (MBS) activity during the second quarter, issuance declined on a year-over-year basis. With average home prices reaching record highs, home buyers and investors continue to look for affordable and innovative ways to finance real estate properties. Adjustable rate mortgages (ARM) have increased in popularity during the last couple of years, and Fannie Mae and Freddie Mac are less likely to guarantee MBS backed by ARMs, which exhibit higher credit risk characteristics. From 1993 to 3, ARMs accounted for an average of 3 percent of all mortgage originations, according to the Mortgage Bankers Association. By contrast, ARMs represented 35 percent of total origination volume in 4 and 33 percent in the first half of 5. In addition, even with the increase in the conventional loan limit, growth in demand for jumbo mortgages and other nonconforming products has contributed to the year-over-year agency issuance trend. Private-label issuers are able to securitize jumbo mortgages in excess of the conforming loan limit and are more likely to take on additional exposure from riskier loans, such as ARMs, sub-prime and Alt-A. Issuance of private-label MBS increased to $38.7 billion in the first half of the year, up from the $17.4 billion issued in the first half of 4. Looking ahead, the mortgage market will continue to benefit from the strength of the housing sector, as exemplified by record home sales volumes. While most observers anticipate some moderation in housing, most rule out a housing bust scenario. Mortgage securities issuance volumes would be adversely affected should interest rates continue to climb. Agency MBS and CMO Driven by origination volume growth, all three agencies Fannie Mae, Freddie Mac and Ginnie Mae increased issuance of MBS by 15. percent in the second quarter. Agency issuance totaled $9.1 billion, up from the $198.8 billion in the first quarter. For the first half of the year, new issue activity decreased 6. percent, to $47.9 billion, compared to the same period one year ago. Agency collateralized mortgage obligations (CMO) issuance decreased to $169.9 billion in the first half of the year, down from the $196.4 billion issued one year ago Issuance of Mortgage-Related Securities :Q 1 1 Agency MBS/CMO Private-Label MBS Issuance of Agency Mortgage-Backed Securities :Q FHLMC FNMA GNMA Average Daily Trading Volume of Agency Mortgage-Backed Securities (1) :Q (1) Primary dealer activity 4 MBA Refinance Index vs. Freddie Mac 3 Year Monthly Average Commitment Rate (*) Jan. Jun. 5 1/ * Includes fees and points 1/3 1/4 Refinance Index Freddie Mac 3 yr 1/5 4 5 % 5 Sources: Fed. Agencies, Thompson Financial, Inside MBS & ABS, Bloomberg Sources: GNMA, FNMA, FHLMC, Bloomberg /5 Sources: Freddie Mac, Mortgage Bankers Association of America Source: Federal Reserve Bank of New York The Bond Market Association Research Quarterly 8

9 Funding and Money Market Instruments Outstanding Repo Volume Continues to Increase Through Q The average daily volume of total outstanding repurchase (repo) and reverse repo agreement contracts totaled $5.47 trillion in the first half of 5, an increase of 17.4 percent from the $4.66 trillion from the daily average outstanding during the same period a year ago. Daily outstanding repo agreements increased 17.1 percent, to an average of $3.17 trillion through the first six months. Average daily outstanding reverse repurchase agreements increased to $.9 trillion in the first two quarters. The data represent financing activities of the primary dealers reporting to the Federal Reserve Bank of New York and include repo and reverse repo agreements involving U.S. government, federal agency, agency mortgagebacked and corporate securities. The Fixed Income Clearing Corporation s Government Securities Division (GSD), an SEC registered clearing agency, facilitates orderly settlements in the U.S. Government securities market and tracks repo trades settled through its system by product type. Through the second quarter of 5, over $4. trillion in repo trades were submitted by GSD participants, with an average daily volume of approximately $1.6 trillion. Transactions involving Treasury notes accounted for the largest share of GSD s repo activity, representing $146.5 trillion or 71.7 percent of total volume. Repos involving Treasury bills accounted for an estimated $14.6 trillion, or 7. percent of the total. Treasury bonds accounted for $15.4 trillion of the activity for the year. Transactions involving federal agency non-mortgage securities were second to Treasury notes in volume, accounting for $.3 trillion or 9.9 percent of 5 s volume for the first six months. Money Market Outstanding Volume Rises; CP Rebound Continues The outstanding volume of money market instruments, including commercial paper (CP), large time deposits and bankers acceptances, totaled $3.15 trillion at the end of the second quarter, a 4.7 percent increase from the total at the end of March 5. CP outstanding totaled $1.51 trillion at the end of June 5, an increase of 4.4 percent compared to the end of March 5. Financial CP outstanding stood at $1.38 trillion at the end of June, 5.3 percent higher than $1.31 trillion outstanding through the first quarter. The use of CP to finance mortgage pipelines drove much of the financial CP growth. However, non-financial CP fell.3 percent, to $16.7 billion at the end of the second quarter and is at its lowest point in 5. Most analysts expect CP outstanding to increase substantially in 5 as businesses will look toward short term debt as a source of financing for working capital and business capital investment growth. Another contributing factor has been the positive trend in CP credit quality, with S&P reporting the lowest proportion of downgrades year-to-date as of early July since The Bond Market Association 5 forecast of $1.47 trillion outstanding by year end appears within reach. The outstanding level of large time deposits rose to an estimated $1.64 trillion as of June 3, 5, a 4.5 percent increase over the volume at the end of March. Bankers acceptances totaled an estimated $4.1 billion at the end of the second quarter, relatively unchanged from outstanding levels in the first quarter. 5 Repurchases The Bond Market Association Research Quarterly Financing by U.S. Government Securities Dealers Average Daily Amount Outstanding :Q 3. % Reverse Repurchases 1* 3 4 * Beginning July 1 corporate securities are included Repo Trades Submitted to the FICC 5:Q YTD Domestic Money Markets Interest Rates Monthly Averages Jan. 3 Jun. 5 1/3 3/3 Treasury Bonds Treasury Bills Total: $4. Trillion *Discount basis Other* 3.6% Federal Agency 5/3 7/3 7.5% 7.1% 9.9% Outstanding Money Market Instruments :Q* 1 *The Bond Market Association estimates 3-Month Certificates of Deposit 3 Month Commercial Paper* 9/3 11/3 1/4 3/4 5/4 71.7% Commercial Paper Large Time Deposits* 3 7/4 9/4 11/4 4 Treasury Notes * Includes Discount Agency, Forward Starting Generic Repo Trades, TIPS Bonds, TIPS Notes 4 1/5 3/5 5 5:Q 6/5 Source: Federal Reserve Bank of New York Source: Fixed Income Clearing Corporation Source: Federal Reserve Systen

10 Special Report: U.S. and European Bond Issuance European and U.S. Fixed Income Issuance Trends : Review and Outlook This month, the Research Quarterly s special topic section looks at longterm U.S. and European (Euro-zone plus United Kingdom) issuance trends in the credit corporate bond and structured and securitized products and government, or sovereign, debt markets during the period since the introduction of the euro, 1999 through 4. (Note that all data are presented in U.S. dollars.) Long-term issuance is defined as debt securities with an original maturity of more than one year. Overview During the latter part of the period, the environment has been supportive of fixed-income market development and issuance on both sides of the Atlantic. From the U.S. perspective, the dominant themes over the latter part of the period have been sustained economic growth following the recovery from the equity market and Internet bubble, historically low interest rates, controlled inflation, demand for dollardenominated fixed-income assets and product development, especially in the structured finance sectors. While economic growth has generally lagged in much of Europe during this period with some notable exceptions, the European marketplace has also benefited from controlled inflation, low interest rates and new product development, especially in structured finance, as well as advances in market integration across national borders. The introduction of the Euro has also contributed to more open cross-boarder trading of securities and securitized products, not to mention removal of foreign exchange volatility and uncertainty within the Euro-zone. Furthermore, these trends are also further evidence of interdependence in the increasingly global marketplace. Total U.S. issuance, including both the credit and government sectors, rose by over 7 percent, from $3. trillion to $5.5 trillion, over the period, with some volatility in annual issuance volumes along the way. Total issuance declined in during the higher interest rate period, ramping up to a $6.8 trillion level in 3 as rates headed to historic lows before moderating last year. European issuance trends in dollar terms showed less volatility, increasing each year, with the exception of, though total European issuance is lower than the U.S. level. Total European issuance in dollar volume rose from almost $1.7 trillion to $.8 trillion during the period. Government Bonds European issuance increased by about 4 percent between 1999 and 4, to $953 billion, dipping in and rising each year since then, actually exceeding the U.S. government issuance volume. The U.S. government volume has risen at a faster pace from $365 billion to $853 billion, also dipping in. The rate of increase in the U.S. has been driven by changes in the federal fiscal position during the period. On both sides of the Atlantic, inflation-protected issuance has grown, though such securities generally have been more prominent in Europe than in the U.S. Corporate Bonds During the period, U.S. issuance has gone from $75 billion ($657 billion investment-grade and $97 billion high-yield) to $76 billion ($618 The Bond Market Association Research Quarterly U.S. and European Bond Issuance Government Bond Issuance 1 Corporate Bond Issuance 1999 Structured Products* Issuance * Includes agency and nonagency MBS, ABS and Pfandbriefe US Europe US Europe 3 4 US Investment-Grade European Investment-Grade US High Yield European High Yield US Europe 4 Sources: Thomson Financial, Dealogic, ECB, DMO, J.P. Morgan Sources: Thomson Financial, Dealogic, ECB, DMO, J.P. Morgan Sources: Thomson Financial, Dealogic, ECB, DMO, J.P. Morgan Sources: Thomson Financial, Dealogic, ECB, DMO, J.P. Morgan

11 Special Report: U.S. and European Bond Issuance continued billion investment grade and $18 billion high-yield), a modest overall decline during a volatile period. Issuance recovered following the investment bubble and related difficulties in the corporate sector beginning in, as rates declined and the credit spreads tightened. From to 4, issuance increased by about 1 percent. Another factor affecting U.S. corporate issuance trends has been the increased reliance on and growth in securitized and structured finance vehicles. In Europe, corporations have traditionally been largely financed through loans. From 1999 to 4, though, corporate bond issuance has increased significantly, from $546 billion ($58 billion investment-grade and $17 billion high-yield) to about $1.1 trillion ($1.3 trillion investment-grade and $6 billion high-yield). There has also been a general trend towards credit spread tightening to the benchmark over much of this period in Europe. The chart illustrating European spreads uses as the benchmark a Bloomberg-generated index of Euro-zone sovereign debt. Securitized and Structured Finance Products In both Europe and the U.S., securitized and structured finance issuance has grown at a significant pace. Several factors are at play: innovative product development, growth in consumer and especially residential mortgage credit, and the favorable rate environment. The issuance data include the entire range of mortgage backed, asset-backed and CDO products across both private sector issuance as well as agency or government sponsored enterprise mortgage-backed securities in the U.S. and Pfanbriefe in Europe. U.S. issuance almost doubled from nearly $1.4 trillion in 1999 to $.6 trillion in 4. European issuance went from $398 billion to $575 billion, an increase of about 44 percent over that period. Outlook Summarizing, fixed income markets on both sides of the Atlantic have benefited from both new product development, a favorable rate environment and controlled inflation. Furthermore, the European marketplace continues to gain from the market integration in the post-euro era and the trend towards less bank financing and more capital market financing. The longer term would suggest continued growth in both Europe and the U.S., with both affected by market dynamics and policy initiatives on both sides of the Atlantic. Issuance levels and trends are ultimately a function of market and economic fundamentals including interest rate levels, credit trends, economic growth, inflation and inflationary expectations, and the attractiveness of debt compared to other financing and investment alternatives. Such variables, of course, affect both issuer supply and investor demand. 15 Basis Points U.S. and European Corporate Spreads Yield % /1 11/1 / 8/1 11/1 / 5/ 5/ 8/ 11/ /3 5/3 8/3 U.S. Ind 1-YR Euro Ind 1-YR 11/3 /4 U.S. and European Government Yields 1 4 8/ 11/ /3 5/3 8/3 11/3 /4 5/4 5/4 8/4 8/4 11/4 UK Sovereign 1-Yr Euro Sovereign 1-Yr 1-YR Treasury 11/4 Sources: Bloomberg Sources: Bloomberg The Bond Market Association Research Quarterly 11