Fixed Income Weekly Review & Preview October 14, 2003 Fixed Income Research Joseph W. Jasper, CFA Director, Fixed Income Strategy & Marketing Portfolio Strategy Group 612-303-5660 joseph.jasper@pjc.com www.piperjaffray.com Yields rose for the second straight week amid encouraging economic data and a rally in stocks. Although we expect rates to continue to trade in a range, the bond market may continue to be susceptible to positive economic news and the recovery in stocks. HIGHLIGHTS Treasuries Treasuries sold off last week amid positive economic reports and a rally in stocks. Treasury Inflation Protected Securities (TIPS) have again reached a point of full valuation in light of current inflation and Break Even Inflation Rates (BEIRs). We recommend investors hold current positions, but would not add to positions given current BEIRs. Agencies There was no shortage of volatility in agencies last week as regulators and politicians grappled over reforms. Meanwhile the FHLBanks are having their own earnings troubles. We continue to believe that any likely reforms regarding oversight of the GSEs will be a long-term positive for bondholders. We continue to see value in short-dated callable structures vs. similar duration bullets. Corporates We anticipate action in cororpates to be driven in part by Q3 earnings releases in the weeks ahead. We continue to encourage investors to focus on lower-rated, economically sensitive sectors. Municipals Municipals sold off in proportion to Treasuries last week, cheapening four to six basis points across the curve. We continue to find value in ten- to 20-year maturities given current valuations. 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: http://www.piperjaffray.com/disclosures. Fixed Income Weekly Review Page 1 of 6 U.S. Bancorp Piper Jaffray
YIELD, COMMODITY, CURRENCY, AND STOCK MARKET (WEEKLY CHANGES) Last Week Prior Week Change (BP) 3 Month 0.90% 0.93% (3) 2 Year 1.63% 1.64% (1) 5 Year 3.13% 3.10% 3 10 Year 4.25% 4.20% 5 30 Year 5.18% 5.09% 9 Curve 2s-10s 262 256 6 Curve 2s-30s 355 345 10 CRB 246.29 243.90 2.39 Crude Oil 31.97 30.40 1.57 Gold 374.1 370.00 4.1 Yen 108.66 110.88 (2.21) Euro 1.1798 1.1569 0.0229 Wilshire 5000 10,085 9,990 95 Dow Jones Ind. Avg. 9,675 9,572 103 NASDAQ Comp. 1,915 1,881 34 Source: Bloomberg Economic Highlights Economic data was scarce last week, however the three reports released all carried a positive tone. Jobless claims unexpectedly dropped by 23,000 to 382,000, and their lowest level since mid-february. Meanwhile, Last week's claims were revised up by 6K to 405K. The trade deficit for August fell to $39.2 billion well below the consensus of $41.5 billion and under the $40.0 reported during July. Both imports and exports fell 2.5% and 2.7% respectively, although the import side of the equation carries a much larger absolute impact, thereby dragging down the total trade gap. Note that over the past five months, exports have risen 1.3% while imports have fallen 2.2%. The lower trade-weighted dollar finally appears to be having a lagged impact. The less than expected trade gap plus other recent positive data points now suggest Q3 real GDP will post an increase well into the five, and possibly six, percent range. A significant (1.2%) jump in food prices led the September PPI up 0.3% versus a 0.1% consensus. The core finished goods PPI was reported flat, largely helped by a 0.5% decline in auto prices. The flat core index is likely to keep the Fed concerned about deflation, especially its effects in very financially leveraged sectors. LAST WEEK S ECONOMIC RELEASES Day Statistic Actual Consensus Estimate Thurs. Initial Claims 395,000 399.000 Continuing Claims 3,662,000 3,673,000 Fri. PPI 0.1% 0.4% PPI Less: Food & Energy 0.1% 0.1% Source: Bloomberg Fixed Income Weekly Review Page 2 of 6 U.S. Bancorp Piper Jaffray
FIXED INCOME STRATEGY Macro Themes Against a backdrop of marginally improving economic fundamentals and a fed on hold, we expect yields continue to trade in a range marked by conflicting economic data. As economic reports show increasing consistency, we would expect intermediate and longer rates to be biased higher. We continue to recommend investors maintain a laddered portfolio structure, taking advantage of the extreme slope of the yield curve and the carry opportunities it offers. As we have suggested over the past few months, the two-year remains well anchored amid a Fed on hold. Meanwhile, although the back end of the curve steppened last week, we continue to believe the best values remain short of 20 years. Again, as yields are likely to be biased higher going into the new-year amid improving economic fundamantals, we encourage accounts to limit the temptation to reach for yields at this time. GRAPH 1 HISTORICAL TREASURY SLOPE 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 Off-the-runs On-the-runs 1.5 Swap Yields 1.0 STRIPS 2002 2007 2012 2017 2022 2027 2032 Source: Bloomberg, U.S. Bancorp Piper Jaffray Treasuries Trading was quiet until Thursday as better than expected labor market data and a stronger equity market took some of the wind out of the bond market. Yields backed up three to nine basis points along the curve with the long/back end underperforming. The curve steepened again last week as 2s to 10s grew six basis points to +262, and 2s to 30s rose ten basis points to +355. On the supply front, the Treasuries $9 billion TIPS reopening was met with solid demand with a bid/cover of 2.25 times. TIPS bonds have handily outperformed their nominal brotheran since we recommended adding to positions in the 1.80% BEIR area a few weeks ago. Fixed Income Weekly Review Page 3 of 6 U.S. Bancorp Piper Jaffray
Agencies It was a week of headline risk in the agencies last week as nearly all the GSEs were a target of some kind or another. First, the FHLBs of Pittsburgh and Atlanta announced that they expect to incur losses of $7 million and $9 million, respectively, in Q3. Immediately following the announcement, S&P placed both of these FHLB banks on negative outlook due to the weakened earnings profile of the two FHLBs and the increasing exposure to interest rate risk in their business profiles. Reaction to the events was generally muted with agency spreads widening marginally on the news. In another development, OFHEO issued a Request for Proposals (RFP) as it seeks an accounting firm to help evaluate the accounting policies at Fannie Mae and examine whether their implementation is resulting in a high level of conformance to GAAP. The House Financial Services Committee delayed discussion of a draft of the GSE regulatory reform bill due to concerns voiced by Wayne Abernathy, the Treasury s assistant secretary for financial institutions. In short, the Administration believes that the current draft of the legislation does not give the Treasury enough regulatory oversight power. Abernathy stated publicly last week that he believes the Treasury should have to the power to approve new business or activities of the agencies, and that the new regulator must have virtually untrammeled authority to set standards of capital reserves to the risks taken by Fannie Mae and Freddie Mac. We continue to believe that any measures designed to create greater scrutiny and supervision of the GSE s would be beneficial to agency debt holders in the long run. On the supply front, FNMA priced a $500 million reopening of their 2.75% 8/11/06 Callable Benchmark Note. FHLMC announced $5 million of a 2-year, and $4 billion of a 10-year Reference Note. Price talk on the two-year is +35 to the two-year Treasury, while the 10-year should be priced at +55 to the current 10-year Treasury. We continue to recommend short lockout callables versus comparable duration bullets, in light of heightened market volatility and attractive spreads. In the event of a rise in rates, we believe callables would outperform similar duration bullets due to their inherent short call position. Given our expectation for a Fed on hold, we continue to believe three-year and shorter yields will remain anchored near current levels. Refi Index / Mortgage Applications The Mortgage Bankers Association s index of mortgage applications jumped 15% to 817.3. The purchase index rose 10.8% to 441.1. The refinancing index surged 19.9% to 3005.5. Corporates Corporates yield spreads narrowed modestly last week with manufacturing, telecom/media and energy bonds putting in the best performance. The average investment-grade corporate bond tightened by three basis points on the week and remains at a five-year low of +111. Fixed Income Weekly Review Page 4 of 6 U.S. Bancorp Piper Jaffray
As mentioned, there was solid investor demand for manufacturing names, especially the autos. Auto paper outperformed significantly on the week with the bonds of GM tightening between 20 and 35 basis points across the curve, while Ford s issues narrowed ten to 15 basis points. GM 6.875% of 12, for example are now trading +212 while Ford 7s of 13 are + 287 a far cry from their +400 and +550 levels of nine months ago. Telecom and Media names, which we have consistently recommended for months, also outperformed last week as spreads tightened in anticipation of a strong earnings season. With the mild back up in spreads during the final week of September, particularly in Telecom, demand for cheaper higher beta paper has increased markedly. We continue to suggest investors focus on lower-rated investment-grade credits, based on our belief that Q3 earnings reports will show sequential financial improvement over Q2. Those companies likely to reap the greatest benefit in terms of price performance will are the more downtrodden, economically sensitive sectors, such as Media/telecom, manufacturing, retailers and financials. Municipals Municipals sold off largely inline with Treasuries last week as yields rose between four and six basis points. In the absence of any major competitive deals being priced, trading was quiet. Given the relatively tight valuations for maturities under ten-years, we continue to favor the ten to twenty-year portion of the municipal curve. MUNICIPAL CONSENSUS YIELD CHANGES FOR THE WEEK Municipal Change % to Treasury Yield (bp) Last Week Previous Wk 5-Year Avg. 2 Year 1.30 6 79.8% 75.6% 77.1% 5 Year 2.44 4 78.0% 77.4% 80.4% 10 Year 3.75 6 88.2% 87.9% 85.4% 30 Year 4.95 5 95.6% 96.3% 94.3% Source: Municipal Market Advisors Fixed Income Weekly Review Page 5 of 6 U.S. Bancorp Piper Jaffray
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. 2003 U.S. Bancorp Piper Jaffray, 800 Nicollet Mall, Suite 800, Minneapolis, Minnesota 55402-7020 Fixed Income Weekly Review Page 6 of 6 U.S. Bancorp Piper Jaffray