In November 2008, the FDIC launched the Temporary Liquidity Guarantee (TLG) program to help issuers of corporate bank debt obtain financing during extremely illiquid and volatile market conditions. Banks participating in the program had to pay a fee, but it was more than offset by the substantially lower borrowing costs of issuing TLG debt rather than traditional Corporate Bonds. The FDIC guarantee of principal and interest payments that gives the bonds a AAA rating expires in December 2012, so bonds must mature before that date. TLG Corporate Bonds are considered “Agency” Bonds, such as Fannie Mae and Freddie Mac traditional debt securities, and therefore included in government bond indexes.
With a market size of roughly $340 billion according to the FDIC, the TLG program has been a success, but further improvements in credit markets suggest future issuance may be limited:
- Banks are shifting focus to issue non-FDIC guaranteed traditional Corporate Bonds.
- The FDIC recently scrapped plans to expand the guarantee to up to 10 years.
- We continue to favor Mortgage-Backed Securities (MBS) among government bonds, but TLG Corporate debt makes a good alternative for investors seeking diversification among government bonds.
Getting Out of TARP
Banks are weaning themselves off FDIC-backed TLG corporate issuance for several reasons. First, issuing non-guaranteed debt is one of the preconditions to repaying TARP funds back to the government. Getting out from under onerous TARP restrictions is a focus for banks. Second, relying on government support programs may convey a sense of weakness to the markets. A bank perceived as being weak may have to pay more to raise capital in the future or face the business risk that customers might be willing to do business only with “strong” banks. Third, prudent debt management suggests spreading our maturity profile of outstanding debt even though TLG issuance is an attractive financing vehicle. And finally, by selling nonguaranteed debt now, banks are taking advantage of notable improvement in corporate debt markets and increased investor risk appetite. In the past several weeks, JP Morgan, Morgan Stanley, Goldman Sachs, US Bancorp, American Express, and even the formerly downtrodden Bank of America and Citigroup have all been able to issue non-guaranteed, traditional Corporate Bonds.
On May 15, the FDIC announced it was scrapping plans to expand the debt guarantee to up to 10 years, suggesting that corporate issuers no longer need the assistance. Negative backlash over using taxpayer funds to assist big corporations has grown, and the government, facing an expanding deficit, is gradually trying to remove stimulus to those areas of the market that no longer need it. The FDIC expanded the TLG guarantee once already—to December 2012 (3.5 years) from June 2012—but the longer extension to 10 years is now off the table. Corporations have until October 2009 to issue TLG debt.
The first offerings of TLG Corporate Bonds came to market at a relatively wide 2.0% yield advantage to comparable maturity Treasury bonds. The issues were well received, and the yield advantage (or “spread”) narrowed to 1.7% within days. Steady demand since has narrowed yield spreads to current levels of 0.25% to 0.70% above comparable Treasuries. This spread is still greater than the 0.18% to 0.35% yield advantage available on comparable Agency Debt but certainly not close to the wide levels of several months ago.
Spread Continues to Narrow
These narrow spread levels are likely to persist, implying a relatively high valuation, as the entire Agency sector continues to benefit from the Federal Reserve (Fed) purchases and investor demand for non-Treasury government bond alternatives. The Fed is in the midst of a $200 billion agency purchase program in an attempt to keep down borrowing costs for Fannie Mae and Freddie Mac and indirectly stimulate the housing market. Fannie Mae and Freddie Mac borrow in the agency market to finance purchase of residential mortgages. Fed buying has led to narrower agency yield spreads, which in turn has helped narrow TLG corporate yield spreads to Treasuries. Aside from Fed purchases, investors are comfortable with even a small yield advantage to low yielding Treasuries given the FDIC backing.
Supply dynamics are also likely to support current valuations as corporations turn away from guaranteed debt issuance that limits growth. As mentioned, TLG corporate debt remains an attractive funding vehicle for corporations,so issuance will continue but likely at a slower pace. Some banks have untapped capacity while some recently approved bank holding companies have yet to issue TLG debt. For the week ending May 15, TLG issuance totaled $4.6 billion, down from a 2009 weekly average of approximately $10 billion according to Bloomberg.
We continue to favor MBS among government bonds, but TLG Corporate Debt makes a good alternative for investors seeking diversification among government bonds. TLG Corporate Debt will continue to be indirectly supported by Fed agency purchases while providing incrementally higher yields than either agencies or Treasuries. Valuations, as measured by narrower yield spreads, are relatively high, but favorable supply/demand dynamics should continue to support valuations and current yield spreads of TLG Corporate Bonds.
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- Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fi xed rate of return and fi xed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. High Yield/Junk Bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors. GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
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