Fixed Income Weekly Review & Preview

Transcription

1 Fixed Income Weekly Review & Preview November 3, 2003 Fixed Income Research Joseph W. Jasper, CFA Director, Fixed Income Strategy & Marketing Portfolio Strategy Group With Q3 GDP out of the way, the market is now likely to fixate on Friday s October employment report. While the report is expected to show a second sequential monthly gain in payrolls, we expect payroll growth to again be sub-par relative to the typical economic recovery. For this and other reasons outlined below, we believe rates will remain rangebound and the Fed will not hint at raising rates until well into HIGHLIGHTS Treasuries Treasuries sold off on the Q3 GDP report, although they managed to recover some of their losses by week s end. Agencies Bullet agency spreads closed mostly unchanged on the week, even as FNMA announced a $1 billion restatement to the owners equity account in their most recent quarterly earnings release. We continue to favor the front-end of the curve, and find value in callables relative to bullets. Mortgages While spreads in the MBS sector continue to tighten, we are constructive on the sector and highlight opportunities in seasoned low-loan balance pools. Corporates Corporate spreads were mostly unchanged on decent investor demand. We continue to like the prospects for lower-rated investment grade credits. Municipals Municipals significantly outperformed Treasuries last week as yields generally rose just one basis point across the curve. We continue to like the value provided in the ten- through 20-year portion of the curve. 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 10 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 0.95% 0.94% 1 2 Year 1.85% 1.72% 13 5 Year 3.28% 3.14% Year 4.30% 4.22% Year 5.16% 5.12% 4 Curve 2s-10s (2) Curve 2s-30s (9) CRB (1.76) Crude Oil (1.05) Gold (4.6) Yen Euro Wilshire ,225 9, Dow Jones Ind. Avg. 9,801 9, NASDAQ Comp. 1,932 1, Source: Bloomberg Economic Highlights The Fed s Open Market Committee members voted unanimously last week to keep the target for the benchmark overnight bank lending rate at a 45-year low of 1%. Almost more importantly, details of the official press release sited the risk of undesirably low price increases are a predominant concern for the foreseeable future. In discussing the overnight lending rate, the FOMC suggested they could keep rates low for a considerable period, which is consistent with text from their previous releases. The considerable period phrase has developed a life of its own as traders and economists try in vain to decipher the true meaning of this cryptic fragment of monetary policy. We believe the Fed will not be moved to action until we see all of the following: Meaningful, consistent jobs creation Consistent, above par GDP growth Consistent inflationary pressures We look at each of these in the following paragraphs. Jobs creation Initial claims fell 5,000 to 386,000, and holding below 400,000 for a fourth straight week. The four-week moving average also dropped, falling to 388,750 from 393,500. Continuing Claims bucked the trend and jumped by 57,000 to million in the week ended October 18. Last week s claims data are supportive of the Federal Reserve s assertion that the labor market appears to be stabilizing. Attention will now be focused on Friday s release of the October employment report as one indication of how long the Fed can realistically remain on hold. The economy added 57,000 jobs in September, the first Fixed Income Weekly Review Page 2 of 10 U.S. Bancorp Piper Jaffray

3 gain since January, and the consensus estimate for October is for payrolls to increase by 50,000. Putting this into a historical context however, the U.S. is still not experiencing monthly employment gains typical of an economy emerging from a recession. The average payroll gain in the months following the 92 recession for example was +170,000. We believe adding another +50,000 jobs during October, as economists expect, will be a nonevent. Further, minimal jobs creation is likely to help keep the unemployment rate elevated, and the Fed on the sidelines. GDP GDP expanded at a 7.2% annual rate from July through September. This is the fastest growth the U.S. has experienced since Q and more than double the 3.3% rise during Q2. Everything about this advance report was positive. Consumer spending grew at a 6.6% pace, the most since the third quarter Business spending rose at an 11.1% annual rate. Finally, the falling Dollar spurred a surge in imports, which contributed 0.84% to growth. Again from a historical perspective, during the recession, the Fed waited a full year and a half ( 92-94) before raising rates. The Fed is known to closely watch the output gap, the difference between actual GDP and potential GDP. A significant output gap is generally associated with an absence of inflationary pressures. Economists estimate the current U.S. output gap at 2.1%. Ultimately, the Fed can remain on hold, as they have openly indicated, watching for signs that excess capacity is being burned up and wage rate pressures are beginning to build. While year-over-year, Q3 GDP grew at a 3.3% compared with a 2.5 percent year-over-year gain in Q2, we believe the Fed will continue to watch from the sidelines for consistent above-par GDP growth. GRAPH 1 PCE VS. CPI-CORE 6.0% 5.0% Personal Consumption Expenditures CPI-Core 4.0% 3.0% 2.0% 1.0% 0.0% 3/1/90 12/1/90 9/1/91 6/1/92 3/1/93 12/1/93 9/1/94 6/1/95 Source: Bloomberg, U.S. Bancorp PiperJaffray 3/1/96 12/1/96 9/1/97 6/1/98 3/1/99 12/1/99 9/1/00 6/1/01 3/1/02 12/1/02 9/1/03 Fixed Income Weekly Review Page 3 of 10 U.S. Bancorp Piper Jaffray

4 Inflation The personal consumption expenditures price index, Alan Greenspan s favorite measure of inflation, rose at a 2.4 percent annual pace following a 0.8 percent gain in the second quarter. Excluding food and energy, the PCE index rose 1.8 percent at an annual rate. While this is an up-tick from Q2, it s only one quarter of data. Other measures of inflation, such as core CPI (+1.2% y/y) and PPI (flat) are still showing a bias to further downside risks (See Graph 1). To summarize, we believe the considerable slack in the economy, soft labor markets and benign inflation are reasons enough for the Fed to remained sidelined for at least the next six months. LAST WEEK S ECONOMIC RELEASES Day Statistic Actual Consensus Estimate Mon. New Home Sales 1,145,000 1,125,000 Existing Home Sales 6,690,000 6,300,000 Tues. Durable Goods 0.8% 1.00% Durable Goods Ex. Trans. 1.2% 1.00% Consumer Confidence Thurs. GDP 7.20% 6.00% Personal Consumption 6.6% 6.30% GDP Price Deflator 1.7% 1.40% Initial Claims 386, ,000 Continuing Claims 3,566, Fri. Personal Income 0.30% 0.20% Personal Spending -0.3% -0.10% Univ. of MI Confidence Chicago Purch. Mgrs Source: Bloomberg THIS WEEK S ECONOMIC RELEASES Day Time Statistic Consensus Previous (CDT) Estimate Mon. 9:00 ISM Wed. 9:00 Factory Orders 0.6% -0.8% 9:00 ISM Nonmanufacturing Thurs. 7:30 Nonfarm Productivity 8.5% 6.8% 7:30 Unit Labor Costs -5.0% -2.8% 7:30 Initial Claims 380, ,000 7:30 Continuing Claims -- 3,566,000 Fri. 7:30 Unemployment Rate 6.1% 6.1% Source: Bloomberg Fixed Income Weekly Review Page 4 of 10 U.S. Bancorp Piper Jaffray

5 FIXED INCOME STRATEGY Macro Themes As the case we laid out above details, we continue to believe that the Fed will remain sidelined for some time. We expect the market to continue to be directional, trading off economic data and its implications for potential Fed moves. Accordingly, we expect the front-end of the curve to continue to lead these directional trades, with the curve steepening on soft data and flattening on more robust reports. However, with the Fed out of the game for the forseeable future, we do not expect the curve to flatten significantly over the balance of the year. We therefore continue to suggest that the roll down and carry opportunities offered through a laddered portfolio structure will provide investors the greatest relative rewards. GRAPH 2 HISTORICAL TREASURY SLOPE Source: Bloomberg, U.S. Bancorp Piper Jaffray Off-the-runs On-the-runs Swap Yields STRIPS Treasuries Treasuries held in reasonably well last week in the face of a much stronger than expected Q3 GDP report (7.2% real GDP, the fastest growth since the first quarter of 1984). The 2s/10s curve flattened almost 11 basis points as the front end continues to lead directional trades in the market. Two-year yields were up 13 basis points on the week while 10s rose only 11 basis points and 30s moved up just four basis points. This week the Treasury will announce details of its quarterly refunding scheduled to be auctioned next week. We expect the Treasury to announce $24 billion threes, $18 billion fives, and $18 billion tens. These supply numbers are consistent with what the Treasury provided in August. Fixed Income Weekly Review Page 5 of 10 U.S. Bancorp Piper Jaffray

6 TIPS continued to outperform last week amid strong investor interest in the asset class. While we expect TIPS to continue garner a lot of attention, we reiterate that TIPS are fully valued at current levels. Breakeven yields are progressively more expensive along the coupon curve. Given a 2.0%-2.5% expected range for inflation, we believe current breakeven yields north of these expectations are excessive and offer little room for outperformance. Agencies Bullet agency spreads finished essentially unchanged on the week. While bullet agency paper and current coupon MBS continue to tighten, new issue callable agencies continue to drift wider. Many callable structures are within striking distance of the wides of late July/early August. We continue to like the opportunities on callable agency bonds given current, cheap valuations. In particular, the two-year maturity sector has seen an increase in issuance in October relative to the levels seen in the third quarter of this year (see Graph 3). This increased supply, along with persistently high levels of short term swaption volatility, and a substantial steepening of the short end of the swap curve in the past month have pushed yield spreads on two year maturity callable Agencies to the widest levels in nearly two years. We find the two-year non-call one-year European structure to be especially compelling as it offers substantial incremental total return versus comparable duration Agency bullets GRAPH 3 2-YR NON-CALL 1-YR NEW ISSUE EUROPEAN CALLABLE SPREADS /1/01 12/1/01 1/1/02 2/1/02 3/1/02 4/1/02 5/1/02 6/1/02 7/1/02 8/1/02 9/1/02 10/1/02 11/1/02 12/1/02 1/1/03 2/1/03 3/1/03 4/1/03 5/1/03 6/1/03 7/1/03 8/1/03 9/1/03 10/1/03 Source: Bloomberg, U.S. Bancorp Piper Jaffray Mortgages As current coupon collateral yield spreads continue to move tighter, we remain neutral on the mortgage basis. Tight absolute spreads though have to be weighed Fixed Income Weekly Review Page 6 of 10 U.S. Bancorp Piper Jaffray

7 against constructive fundamentals, so we don t believe a significant underweight in the sector is warranted. We continue to find value in up in coupon trades as the market remains rangebound and prepayments rates are expected to slow in coming months. We also continue to see value in specified pools of seasoned low loan balance loans. The Federal Reserve s recent statements regarding short term interest rates indicate that the Fed will keep short term rates low for as long as necessary to help spark an economic recovery. For investors in the short end of the yield curve this comes as good news and re-emphasizes the point that carry is king. While many investors have been focused on the CMO segment of this market, we suggest investors also consider the return potential of seasoned premium pass-throughs. These bonds have average life profiles similar to those of short average life CMOs, but may have more attractive prepayment characteristics. The benefits of low loan balance collateral as a source of prepayment protection are considerable. As an example, consider FNMA pool , a 7.5% coupon mega-pool issued in May The pool is a low loan balance pool, with a median average original loan size of $62,550. Over the past nine months, low loan balance collateral has registered one month CPRs that are between 50% and 60% of those for comparable origination generic collateral. Consistent with this behavior, the one-month CPR for FNMA pool is 33.3 as compared to 58.8 for generic pass-throughs of the same origination cohort. As carry is likely to be a substantial component of total return in the near term, we suggest taking on negative convexity in the short end of the yield curve. As an example, we consider a swap out of a short maturity FNMA bullet, FNMA 7.125% of 2/05 and into FNMA pool We highlight the projected total returns for a sixmonth horizon in Graph 4 below. GRAPH 4 COMPARATIVE TOTAL RETURNS 2.0% 1.8% 1.6% FNMA pool and FNMA 7.125% 2/05 (FNMA pool total returns at 100% and 90% of Yieldbook model prepayments) FNMA 7.125% 2/05 100% Model 90% Model Holding Period Total Return 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% Parallel Yield Curve Shift (in bps) Source: Bloomberg, U.S. Bancorp Piper Jaffray Fixed Income Weekly Review Page 7 of 10 U.S. Bancorp Piper Jaffray

8 If we assume that future prepayments occur at 100% of model projections (in this case Yieldbook), the FNMA pool is expected to outperform the Agency bullet in rising rate environments, and in a decline in yields of 38 basis points. Alternatively, if we assume that prepayment rates will occur at 90% of the Yieldbook model projection, we can see the substantially wider range over which the FNMA pool is projected to outperform the bullet. It is interesting to note that for yield increases of greater than 50 basis points, the FNMA pool is projected to perform better under the 100% of the model prepayment scenario than in the 90% scenario. This is due to the extension of the bond s average life under the slower prepayment scenario, and greater price decline in the rising rate environment. Nonetheless, in either prepayment scenario, the FNMA pool is projected to outperform the bullet for increases in yields of over 75 basis points. Corporates Borrowers sold almost $12 billion of bonds, just under the weekly average of $12.5 billion. Meanwhile spreads on investment-grade bonds were three to seven basis points tighter, closing around the +103 area. Among the notable issuers, Altria Group Inc., the parent of cigarette maker Philip Morris, sold $1.5 billion in five-year and 10- year notes and DaimlerChrysler sold $2 billion in a ten-year offering. The issue, which was more than three times oversubscribed, was priced at a spread of +215 to the ten-year Treasury. We continue to favor the debt of lower rated investment-grade companies, especially in the auto, utility, financial and media sectors. Municipals Municipal yields barely rose last week as the market drew firmness from increased investor interest and the absence of significant new supply. We continue to suggest that the best value for taxable investors remains in the ten-year sector, and based on last week s cheapening, would include maturities up to 20 years. MUNICIPAL CONSENSUS YIELD CHANGES FOR THE WEEK Municipal Change % to Treasury Yield (bp) Last Week Previous Wk 5-Year Avg. 2 Year % 75.6% 77.1% 5 Year % 77.4% 80.4% 10 Year % 88.4% 85.4% 30 Year % 95.5% 94.3% Source: Municipal Market Advisors CORPORATE MARKET DETAIL SELECTED NEW ISSUES FROM LAST WEEK Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P UNITED RENTALS NA INC /15/2023 NA 125 B2 B+ JDS UNIPHASE CORPORATION 0 11/15/2010 NA 475 NA NA WASHINGTON MUTUAL INC /3/ A3 BBB+ WASHINGTON MUTUAL INC 4 1/15/ A3 BBB+ PNC FUNDING CORP /15/ A3 BBB+ Fixed Income Weekly Review Page 8 of 10 U.S. Bancorp Piper Jaffray

9 Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P HOST MARRIOTT LP /1/ Ba3 /*- B+ CIT GROUP INC /3/ A2 A UNITED RENTALS NA INC /15/ B2 B+ ODYSSEY RE HOLDINGS /1/ NA BBB- MANTIS REEF LTD /14/ A3 A- GAYLORD ENTERTAINMENT CO 8 11/15/ B3 B- WASHINGTON MUTUAL INC /3/2005 NA 400 A3 BBB+ DURA OPERATING CORP /15/2012 NA 50 B1 B+ EMPIRE DISTRICT ELEC CO /15/ Baa2 BBB- NEIGHBORCARE INC /15/ Ba3 B+ HEALTH CARE REIT 6 11/15/ Baa3 BBB- QUEBECOR WORLD INC /15/ Baa2 BBB- QUEBECOR WORLD INC /15/ Baa2 BBB- CENTERPOINT ENERGY RES /15/ Ba1 BBB NALCO COMPANY 9 11/15/ Caa1 B BANK OF NEW YORK CO INC /15/ Aa3 A+ NALCO COMPANY /15/ B2 B NALCO COMPANY /15/ Caa1 B NALCO COMPANY /15/ B2 B SOUTH CAROLINA ELEC&GAS /1/ A1 A- DAIMLERCHRYSLER NA HLDG /15/ A3 BBB NISOURCE FINANCE CORP /4/2005 NA 250 Baa3 BBB NISOURCE FINANCE CORP /1/ Baa3 BBB HCA INC /6/ Ba1 BBB- HCA INC /6/ Ba1 BBB- BRASKEM SA /5/ NA NA CINCINNATI BELL INC /15/ B3 B- O'CHARLEYS INC 9 11/1/ Ba3 B ALTRIA GROUP INC 7 11/4/ Baa2 BBB ALTRIA GROUP INC /4/ Baa2 BBB SILGAN HOLDINGS INC /15/ B1 B+ AMERICAN HONDA FINANCE /6/ A1 A+ ZIONS BANCORP 2.7 5/1/ A3 BBB TELEX COMMUNICATIONS INC /15/2008 NA 125 B3 B INTL TELECOM SATELLITE /1/ Baa3 BBB+ INTL TELECOM SATELLITE /1/ Baa3 BBB+ INTL LEASE FINANCE CORP /1/ A1 AA- Source: Bloomberg Fixed Income Weekly Review Page 9 of 10 U.S. Bancorp Piper Jaffray

10 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 10 of 10 U.S. Bancorp Piper Jaffray