That was the message from last week’s FOMC meeting when the Federal Reserve maintained the target Federal Funds rate between 0.00% to 0.25% and reiterated that the “exceptionally low” rate would persist for “an extended period”. The Fed also extended its agency mortgage-backed security (MBS) program through March 2010 versus an original termination of year-end 2009 and committed to buying the full $1.25 trillion. Similarly, agency debt purchases were also extended through March 2010 with the Fed stating it could buy “up to $200 billion”.
The low Fed Funds rate keeps all high quality short-term bond yields very low and pushes investors into longer maturity bonds. With 6-month t-bill yields below 0.20%, bond investors can move into 2-year Treasuries at 0.98% and nearly quintuple their yield. Investors are easily motivated to make this trade given the low yield on t-bills and other money market instruments and the fact that the 2-year note is still relatively insensitive to interest rate changes. Investors who might normally focus on 2-year notes extend to 3-year securities, and so on. In sum, the low level of short yields pushes investors into longer-term maturities in search of higher yields.
The Fed's Commitment
The Fed’s commitment to keep the Fed Funds rate low for an “extended period” also supports the shift into longer bonds as it gives investors the added confidence to switch into longer maturity bonds. The Fed would likely remove this terminology well in advance of any interest rate increase giving investors ample notice of a shift in policy. Since the Fed meets every six weeks this could amount to several months. We do not expect the Fed to raise interest rates until the second half of 2010.
The Fed’s continued support of agency MBS and agency debt will likely keep yield spreads to Treasuries very narrow and motivate investors into higher yielding bond sectors such as corporate bonds, high yield, and emerging market debt. Fed purchases were one of the key factors leading to narrow yield spreads for both MBS and agencies. Yield spreads for both sectors remain near historically narrow levels. The average “current coupon” MBS security offers a yield advantage of 0.90% to comparable Treasuries while agencies offer a yield advantage of 0.10% to 0.45% depending on maturity. Narrow yield spreads are a reflection of high valuations but they are likely to remain high as long as the Fed keeps buying.
High MBS and agency valuations have helped push investors into sectors where valuations remain cheap by historical comparison. Investment grade corporate bonds possess an average yield spread of 2.2% to Treasuries, which is above the historical average of 1.5% and notably greater than MBS spreads. Similarly, yield spreads on high yield bonds of 8.1% are also well above their historical averages of 5.6%. The average yield spread on emerging market debt of 3.4% is below the long-term average of 5.0%, but above the 3.2% average spread over the past five years which we find more relevant given higher overall credit quality. Emerging market debt credit quality has improved with an average rating of BBB versus BB 10 years ago.
Potential risks, such as heavy Treasury supply and the eventual absence of Fed support, do exist but are likely to be dominated by the two factors above in the near-term. Heavy issuance has not been a problem for the Treasury market since early June, but could become a factor again in pushing yields higher. The end of Fed support could also disrupt the bond market and lead to higher interest rates. Fed Treasury buying, which has been tapering down and ends in October, has so far not had an impact to interest rate levels. However, the lack of Fed buying, even if modest, could have an adverse reaction come November.
Another Look at MBS
Fed buying has been most significant in the MBS market where purchases amount to roughly 25% of the market. The Fed will taper purchases in the MBS market as well. At first, the impact will be minor but as time goes on the gradual removal of a significant market presence could lead to cheaper valuations (wider yield spreads). Investors currently drawn to corporate and high yield bonds may rethink exposure depending on relative attractiveness.
However, over the near-term we think the move into longer maturity bonds and lower rated bonds continues. As an example, the day after the FOMC announcement, the 7-year Treasury note auction met strong demand and notably better than witnessed at the 2 and 5-year note auctions in the days prior. The Fed’s commitment gave investors confidence to extend maturity and helped another round of record Treasury supply to go off without a hitch. Furthermore, over the coming five weeks, the Treasury is winding down its Supplementary Financing Program (SFP). The SFP, which consists entirely of t-bills was launched last fall in response to the credit crisis and to ensure sufficient liquidity in money markets. The Treasury has decided not to reissue t-bills and $185 billion will be returned primarily to the market as the t-bill market shrinks by roughly 10%. This new cash will exert additional downward pressure on short-term yields and motivate investors to extend maturity or move into higher yielding fixed income securities.
In essence, the Fed essentially continues to support the current range bound yield environment while motivating investors to take risk in the bond market. While we are mindful of potential risks, this backdrop continues to bode well for riskier segments of the bond market such as corporate bonds, high yield, and emerging market debt.
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