Fixed Income Weekly Review & Preview

Transcription

1 Fixed Income Weekly Review & Preview May 3, 2004 Fixed Income Research Joseph W. Jasper, CFA Director, Fixed Income Strategy & Marketing Private Client Research We continue to operate under caution as the market girds for both the FOMC meeting and Friday s April employment report. We continue to expect the Fed to be methodical and collect several months worth of data before moving on rates. HIGHLIGHTS Treasuries Treasury yields rose modestly last week on stepped up inflation readings. TIPs recovered slightly, but we continue to believe their period of underperformance is at hand. We look for TIPS to continue to cheapen (underperform) through the summer. Mortgages We recommend a continued overweight in higher coupon passthroughs Agencies Discount callable and step-ups abound with the recent back up in yields. We believe these structures offer decent yield pick up versus comparable duration bullets given our outlook for upwardly biased rates and a flatter yield curve. Corporates With the majority of S&P companies reporting, Q1 earnings look terrific. We continue to recommend an overweight in lower-rated economically sensitive credits. Municipals It s all about the $7 billion+ Cal State GO loan being priced early this week. We suggest investors take what we believe will be a last opportunity to capture Cal paper on the cheap. 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 5 Piper Jaffray

2 YIELD, COMMODITY PRICE, CURRENCY, AND STOCK MARKET CHANGES FOR THE WEEK LAST WEEK PRIOR WEEK CHANGE (BP) 3 Month 0.97% 0.97% 0 2 Year 2.32% 2.23% 9 5 Year 3.62% 3.56% 6 10 Year 4.51% 4.46% 5 30 Year 5.29% 5.25% 4 Curve 2s-10s (4) Curve 2s-30s (5) CRB Crude Oil Gold (8.2) Yen Euro Wilshire ,794 11,150 (356) Dow Jones Ind. Avg. 10,226 10,473 (247) NASDAQ Comp. 1,920 2,050 (130) Source: Bloomberg ECONOMIC HIGHLIGHTS The pace of new home sales rose 8.9% in March to a record high of million units. Meanwhile, sales of existing homes also grew at their fastest pace in more than two years. Sales jumped 5.7% to 6.48 million units. A dip in mortgage interest rates and improving economic fundamentals helped propel sales. Consumer confidence increased 4.4 points to 92.9 in April, while March s value was revised up 0.2 to Both components of the index rose in the month with the present situation component leading the way. The Chicago PMI jumped ahead of expectations in April, rising to a threemonth high of Jobless claims fell 18,000 last week to 338,000, just below expectations. Continuing claims edged up 3,000 and remain above the 3 million mark. Real GDP rose at an annual rate of 4.2% in Q1, well below the expected 5%- 6% rate. This was a bit of a surprise given the surge in mortgage refinancings and the $27 billion in tax refunds received during Q1. Federal estimates suggest roughly 80% of the tax refunds went directly into savings versus 0% in 2003Q3. The GDP price deflator rose at a 2.5% annual rate versus 1.5% in Q4 and the fastest pace since 2001Q2. Meanwhile the core PCE deflator picked up at a 2% annual rate. The employment cost index jumped 1.1% due largely to the 2.4% surge in benefits. Excluding benefits, wages and salaries grew at a subdued 0.6% quarterly pace. Fixed Income Weekly Review Page 2 of 5 Piper Jaffray

3 On balance, economic data continue to point to improving conditions. As for the FOMC meeting this week, we expect the Fed to leave rates on hold, but alter the tone of their message to acknowledge the recent acceleration in both growth and inflation measures. Still, we believe the Fed will want to examine several months worth of data before making any tightening move. In our opinion, the Fed will have to weigh the up tick in inflation measures (we believe this is temporary, given the rolling over of commodities prices) versus higher market interest rates, a listless stock market, stronger Dollar, and persistently high energy costs. Finally, expectations for April payrolls are in the +125,000 range, well below the typical +200,000 post recession trend. We would also not be surprised to see the March payroll data revised downward. The last time the Fed raised rates coming out of a recession monthly payrolls had averaged +200,000 per month for 12 months. LAST WEEK S ECONOMIC RELEASES DAY STATISTIC ACTUAL CONSENSUS ESTIMATE Monday New Home Sales 1,228,000 1,173,000 Tuesday Consumer Confidence Existing Home Sales 6.48M 6.20M Thursday Gross Domestic Product 4.2% 5.0% GDP Price Deflator 2.5% 2.0% Personal Consumption 3.8% 4.2% Employment Cost Index 1.1% 0.9% Initial Jobless Claims 338, ,000 Continuing Claims 3,013,000 3,000,000 Friday U. of Michigan Sentiment Personal Spending 0.4% 0.7% Personal Income 0.4% 0.4% Chicago Purchasing Manager Source: Bloomberg THIS WEEK S ECONOMIC RELEASES DAY TIME STATISTIC CONSENSUS PREVIOUS (CDT) ESTIMATE Monday 9:00 ISM Manufacturing :00 ISM Prices Paid :00 Construction Spending 0.6% -0.1% Tuesday 9:00 Factory Orders 2.3% 0.3% Wednesday 9:00 ISM Non-Manufacturing Thursday 7:30 Continuing Jobless Claims -- 3,013,000 7:30 Initial Jobless Claims 338, ,000 Friday 7:30 Non-Farm Productivity 3.5% 2.6% 7:30 Unit Labor Costs -0.5% -0.4% 7:30 Avg. Hourly Earnings 0.2% 0.1% 7:30 Avg. Weekly Hours :30 Unemployment Rate 5.7% 5.7% Source: Bloomberg Fixed Income Weekly Review Page 3 of 5 Piper Jaffray

4 FIXED INCOME STRATEGY Treasuries Yields rose between four and nine basis points on the week as the up tick in inflationary measures sent ten-year yields through the 4.50% mark. The curve also continues to flatten as speculation grows over a Fed rate hike. The Treasury will announce the details of their quarterly refunding on Wednesday. We expect a package of $24 billion three-year notes, $16 billion five-year notes and $15 billion ten-year notes. The Treasury may also use this occasion to announce plans to add a 20-year TIPS security to their July auction, and ratchet down the size of the ten-year auction. GRAPH 1 HISTORICAL TREASURY SLOPE Source: Bloomberg, Piper Jaffray Off-the-runs On-the-runs Swap Yields STRIPS Agencies The flattening of the yield curve means the roll down and carry game is coming to an end. Investors took advantage of the steep shape of the curve by positioning bullets that rose in price as they aged, and by positioning callables on the expectation that the bonds would be called. We believe a flatter curve/rising rate environment is still a perfect time to consider callables. Discount callables and step-ups trade like bullets because they are essentially out of the money. However they offer decent yield pick up relative to bullets due to their inherent optionality. To maximize this yield differential, we recommend Bermudan calls due to their greater optionality relative to European or one-time call paper. We offer an example using a recently issued FHLB step-up with a 15 year final maturity, callable every six months. Fixed Income Weekly Review Page 4 of 5 Piper Jaffray

5 Step-ups are notoriously hard to analyze due to their optionality. Because this bond is trading below 98 and out of the money, we ignore the fact that the coupon steps up 50 basis points every three years until reaching 7%, and instead assume it is a bullet. We offer two alternative views. GRAPH 2 COMPARATIVE HOLDING PERIOD ADVANTAGE: FHLB 5% 5/2/19-04 Step-up vs. FHLB 2.785% 4/27/07 (Three year holding period, constant OAS) Yield Curve Total Return Step-up Shift (bps) OAS Step-up Bullet Advantage % 3.09% 2.88% % 3.11% 2.90% % 3.12% 2.87% % 3.14% 2.68% % 3.16% 2.12% % 3.17% 1.29% % 3.19% Source: Bloomberg, Piper Jaffray 0.31% As Graph 2 highlights, our first alternative assumes the step-up gets called on its first step date, 4/23/07. Accordingly we compare the step-up to a three year FHLB bullet. The outsized coupon allows the step-up to outperform comfortably over a 300 basis point range, even in an up 150 basis point scenario. GRAPH 3 YIELD TO CALL FOR FHLB 5% 5/2/19-04 Step-up 10 9 FHLB 5% 5/3/19-04 Spread over On-the-run Bullets Yield/Spread (in basis points) Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Nov-15 Nov-16 Nov-17 Nov-18 Source: Bloomberg, Piper Jaffray Fixed Income Weekly Review Page 5 of 5 Piper Jaffray

6 Scenario two (See Graph 3) illustrates step-up s yield to every call date, again assuming no step-up in coupon. We also plot the step-up s yield spread over benchmark bullet issues. Again the step-up offers outsized yield pick up relative to bullets over the 15 year life of the bond. Refi Index / Mortgage Applications The Mortgage Bankers Association s index of mortgage applications rose 0.5% to The purchase index increased by 6.8% to The refinancing index dropped 5.8% to Corporates Fully 76% of S&P 500 firms have reported Q1 earnings. The results thus far have been compelling, and only confirm our belief that investors should continue to overweight lower-rated, economically sensitive credits. More than 95% of companies reporting had positive EPS, with 75.6% reporting above consensus. Median net income growth was 23.2%. An intended benefit of our call for exposure to economically sensitive credits is positive ratings migration. While the ratings of Ford and GM were only affirmed last week by Moody s, we believe the ratings agencies are starting to take note of the turnaround in operational performance at companies such as these. Autos of course remain one of the cheapest sectors in the investment grade universe, and we continue to recommend the sector specifically. Municipals Muni yields jumped between nine and 13 basis points last week. Munis were generally for sale all week with bids-wanted via Bloomberg rising steadily ahead of next week s super-sized Cal State deal and the FOMC meeting, both on May 4. In addition, data from AMG indicated municipal mutual funds had net outflows of $513 million last week, the fifth straight weekly outflow. We have mentioned in previous Weeklys that the March into May timeframe is a notoriously weak period of demand for municipals. This year for example, cash flows to investors from bond maturities and interest payments total an estimated $16 billion, far below their projected June and July peaks of $48 billion and $33.7 billion respectively. Looking ahead, the main event this week will be the pricing of $7-8 billion in Cal State GOs, beginning Monday. The loan is composed of $6 billion in callable Series 2004A bonds and $1 billion of Series 2004B bonds which are subject to mandatory tender. The deal is rated Aa3/AA+ and will be secured by the proceeds from the State s Fiscal Recovery Fund, in addition to an overriding general obligation pledge. The State s existing GO s are rated Baa1/BBB. As we mentioned last week, yields on Cal State GO s have narrowed relative to AAA-rated bonds as perceptions over the State s fiscal condition has improved. Demand for the state s last two loans in fact, has been strong with heavy institutional and retail interest. However, we believe the sheer size of the ERB deal will dictate that the loan is priced cheap to the triple-a scale in order for the deal to be auctioned successfully. We expect the ERB loan to be priced between 10 and 25 basis points cheap to the triple-a scale. Fixed Income Weekly Review Page 6 of 5 Piper Jaffray

7 We suggest investors looking for decent yields on an improving story consider acting this week. We believe the pricing of the ERB loan this week will temporarily cheapen old Cal State GO paper as well. Closing trades on Friday suggested 30-year Cal GOs were trading at 100% of Treasury yields. Anyone contemplating buying Cal State paper should consider this week one of the last times Cal State GOs will trade so cheap. MUNICIPAL CONSENSUS YIELD CHANGES FOR THE WEEK MUNICIPAL CHANGE % TO TREASURY YIELD (BP) LAST WEEK PREVIOUS 5-YEAR AVG. WK 2 Year % 77.6% 77.1% 5 Year % 77.5% 80.4% 10 Year % 86.3% 85.4% 30 Year % 93.5% 94.3% Source: Municipal Market Advisors CORPORATE MARKET DETAIL CORPORATE RATINGS CHANGES Issuer Ratings Action Rating To From Moody s / S&P AT&T Corp Watch Neg. -- Baa2/BBB Cendant Corp Stable Negative Baa1/BBB CNF Inc Stable Negative Baa3/BBB- Comcast Corp Rev. for Upgrd. -- Baa3/BBB CVS Corp A- A A2/A- International Game Technology Positive Stable Baa3/BBB International Paper Company Negative Stable Baa2/BBB John Hancock A+ A A3/A+ MetLife Inc. Stable Negative A3/A- Newmont USA Ltd. Baa2 Baa3 Baa2/BBB News Corporation Inc. Rev. for Upgrd. -- Baa3/BBB- Pegasus Communications Corp CC CCC- Ca/CC Nortel Networks Rev. for Dwngrd. -- B3/B- Piedmont Natural Gas Stable Negative A3/A Prudential Financial Inc. Stable Negative A3/A- Staples Inc. Positive Stable Baa2/BBB- Schering Plough Rev. for Dwngrd. -- A3/A- Trico Marine Watch Dev. -- Caa3/CCC- TXU Corp Developing Negative Ba1/BBB- Volkswagen AG Rev. for Dwngrd. -- A2/A *: CreditWatch Developing *-: Review for Downgrade/CreditWatch Negative *+: Review for Upgrade/CreditWatch Positive Fixed Income Weekly Review Page 7 of 5 Piper Jaffray

8 SELECTED NEW ISSUES FROM LAST WEEK Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P TRIAD HOSPITALS INC 7 5/15/ B2 B+ SENECA GAMING CORP /1/ B2 BB- UNION PACIFIC CORP /1/ Baa2 BBB UNION PACIFIC CORP /1/ Baa2 BBB ARCH CAPITAL GROUP LTD /1/ NA BBB- VALMONT INDUSTRIES INC /1/ Ba3 B+ TENASKA VIRGINIA PARTNRS /30/ Baa3 BBB- TRANSKARYOTIC THERAPIES /15/2011 NA 90 NA NA SEA CONTAINERS LTD /15/ B3 B SLM CORP /15/ A2 A CITIGROUP INC /5/ Aa1 AA- SUSQUEHANNA BANCSHARES /1/ Baa2 BBB- CENTEX CORP 5.7 5/15/ Baa2 BBB GIANT INDUSTRIES 8 5/15/ B3 B- EMMIS OPERATING CO /15/ B2 B- LITHIA MOTORS INC /1/2014 NA 85 NA NA MEDAREX INC /15/2011 NA 150 NA NA E.I. DU PONT DE NEMOURS /30/ Aa3 NA E.I. DU PONT DE NEMOURS /30/ Aa3 NA GOVERNMENT OF JAMAICA /20/2017 NA 425 B1 B CNF INC 6.7 5/1/ Baa3 BBB- AMSCAN HOLDINGS INC /1/ B3 B- KOREA MIDLAND POWER CO /6/ A3 A- EUROPEAN INVESTMENT BANK /15/2014 NA 1500 Aaa AAA REEBOK INTL LTD 2 5/1/2024 NA 300 NA BBB REPUBLIC OF PHILIPPINES /15/2014 NA 1700 Ba2 BB REPUBLIC OF PHILIPPINES /15/ Ba2 BB ASIF GLOBAL FINANCNG /3/2007 NA 1250 Aaa AAA JACKSON NATL LIFE FUND NA 5/1/2014 NA 50 A1 AA REPUBLIC OF PERU /3/ Ba3 BB- QUEBEC PROVINCE /5/ A1 A+ WASTE SERVICES INC /15/2014 NA 160 Caa1 B- Source: Bloomberg Fixed Income Weekly Review Page 8 of 5 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 the subject security. In addition, no part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in this report. Research Disclosures The following disclosures apply to stocks mentioned in this report if and as indicated: (#) Piper Jaffray was making a market in the Company s securities at the time this research report was published. Piper Jaffray will buy and sell the Company s securities on a principal basis. (^) A Piper Jaffray analyst who follows this Company or a member of the analyst s household has a financial interest (a long equity position) in the Company s securities. (@) Within the past 12 months, Piper Jaffray was a managing underwriter of an offering of, or dealer manager of a tender offer for, the Company s securities or the securities of an affiliate. (>) Piper Jaffray has either received compensation for investment banking services from the Company within the past 12 months or expects to receive or intends to seek compensation within the next three months for investment banking services. (~) A Piper Jaffray analyst who follows this Company, a member of the analyst s household, a Piper Jaffray officer, director, or other Piper Jaffray employee is a director and/or officer of the Company. (+) Piper Jaffray and its affiliates, in aggregate, beneficially own 1% or more of a class of common equity securities of the subject Company. Disclaimer Piper Jaffray research analysts receive compensation that is, in part, based on revenues of Piper Jaffray Equities & Investment Banking which include overall investment banking revenues. Piper Jaffray research analysts who follow this Company report to the Head of Investment Research who, in turn, reports directly to the Chief Executive Officer of Piper Jaffray. This material is based on data obtained from sources we deem to be reliable; it is not guaranteed as to accuracy and does not purport to be complete. This information is not intended to be used as the primary basis of investment decisions. Because of individual client requirements, it should not be construed as advice designed to meet the particular investment needs of any investor. It is not a representation by us or an offer or the solicitation of an offer to sell or buy any security. Further, a security described in this release may not be eligible for solicitation in the states in which the client resides. Officers or employees of affiliates of Piper Jaffray & Co., or members of their families, may have a beneficial interest in the Company's securities and may purchase or sell such positions in the open market or otherwise. Notice to customers in the United Kingdom: This report is a communication made in the United Kingdom by Piper Jaffray & Co. to market counterparties or intermediate customers and is exclusively directed at such persons; it is not directed at private customers and any investment or services to which the communication may relate will not be available to private customers. In the United Kingdom, no persons other than a market counterparty or an intermediate customer should read or rely on any of the information in this communication. Securities products and services offered through Piper Jaffray & Co., member SIPC and NYSE, Inc., a subsidiary of Piper Jaffray Companies. Additional information is available upon request. No part of this report may be reproduced, copied, redistributed or posted without the prior consent of Piper Jaffray & Co Piper Jaffray & Co., 800 Nicollet Mall, Suite 800, Minneapolis, Minnesota Fixed Income Weekly Review Page 9 of 5 Piper Jaffray