Treasury FRN issuance will eat into supply of bills

In January the US Treasury will auction off the first set ($10-15bn) of floating rate notes (FRNs). These are two-year notes with quarterly payments based on the 3-month treasury bill rate plus (or minus) some small spread. The notes will be auctioned off at par, with the premium/discount built into the spread (see term sheet below). It has been some 17 years since the US Treasury has introduced a new product. The demand for "floaters" has been strong as fixed income investors grapple with rising rates. The rally in senior leveraged loans for example (see post) has been driven to a large extent by the fact that the coupon on these products rises as rates increase. And now the Treasury will attempt to take advantage of this demand.

The 3-month treasury bill rate is currently around 7bp vs. the 2-year note yielding about 34bp. So why would someone accept such a low rate on a 2-year product when they can lock in a higher rate with a fixed rate note? The reason is that the market expects the 3-month bill rate to rise quite sharply in the next couple of years. Therefore while the expectation is that the FRN buyer will make much less at the beginning, at some point the coupon will rise above the current 2-year note rate to compensate investors for the lower initial yield. Ultimately (in an "arbitrage-free" world), the expected effective yield on a 2-year FRN and a 2-year fixed-rate note issued by the US Treasury should be roughly the same.

Illustration

Who will buy these products? The biggest demand will come from money market investors - those who currently buy bills. Because the FRNs are equivalent to "rolling" a three-month bill, rated money market mutual funds now have permission from the rating agencies to buy the notes. S&P released a statement recently saying that the "new U.S. Treasury Floating-Rate Notes are consistent with our principal stability fund ratings criteria".

There is some concern however that this FRN program will reduce the amount of treasury bills available in the market, particularly as the Treasury attempts to lengthen the average maturity of total debt outstanding.

JPMorgan: - Going forward, we expect Treasury to err on the side of caution, and our forecast assumes $10bn in monthly FRN issuance until the program is more developed. Furthermore, our issuance forecast shows FRNs as a substitute for Treasury bill issuance, consistent with the goal of lengthening the weighted-average maturity (WAM) of the Treasury debt.

As discussed back in July (see post), treasury bills as a percentage of total government debt have been on a decline for some time, and the new FRNs are expected to further reduce this supply.

Source: JPMorgan

FRN Term Sheet

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From our sponsor:

Total equity offerings in the US hit an all-time record

In spite of poor performance of a number of high profile IPOs this year (won't name any names here), the demand for new issue equity in the US seems to be quite resilient. In fact the total IPO volume this year is the highest since the burst of the tech bubble.

Source: The Leuthold Group

Furthermore, if one includes the secondary stock issuance (vs. just the initial offerings), the amount of new paper hitting the market is at an all-time record this year.

IPOs plus "secondary equity financings (follow-on offerings from existing public companies), as well as secondary distributions (where proceeds go to the selling shareholders)". (Source: The Leuthold Group)

Who is buying all these shares? Except for a couple of high profile cases, individual investors don't seem to be involved on a large scale. In fact on a net basis it certainly doesn't seem to be coming from mutual funds, as investors continue to pull record amounts.

Source: The Leuthold Group

The funding for new shares seems to be coming from institutions (as well as institutional funds they invest in) that are pushed to the limit by low interest rates. Pensions and insurance firms seem to be forced to move up the risk ladder in order to meet their obligations and, as a consequence, the primary equity market may be the beneficiary.



h/t Nick Gogerty

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Are fixed income ETFs the new "securitization" product?

Larry Fink of BlackRock must be cracking open the Champagne again. The BlackRock junk bond ETF (HYG) has hit another record in shares outstanding. HYG market cap is now approaching $15bn, generating substantial fees for BlackRock. And Fink's banker friends should be quite happy as well. Not only do they make money creating new HYG shares and capturing the premium, but HYG and other HY ETFs are gobbling up new issue HY bonds at record low yields, generating fees for banks. Plus all the brokerage fees, advisory services, and custody. The sausage factory is in full swing.

How banks generate fees on ETFs

Wall Street has found the new "securitization" machine - with or without leverage.

BW: There's no relief in sight for those feeling overwhelmed, as a wave of new fixed-income ETFs reaches investors. Until recently, bond ETF pickings were pretty slim, but fund giants such as BlackRock are busy slicing and dicing fixed-income securities into tightly targeted offerings. Since 2009, the number of bond ETFs has risen from 52 to 191, and more wait in the wings.

As liquidity continues to increase (see M2 chart below - nearing $10 trillion) and rates stay near zero, demand for this product is climbing rapidly. Maybe it is time to ask the question: are we building another bubble with fixed income ETFs?

Fixed income historical ETF performance has certainly been very good in the past two years, but it is clearly a key area to watch for signs of "froth".

Fixed income ETFs total returns over the past two years  (not annualized)

In the mean time retail cash continues to flow in, with $125mm coming into HYG on Friday alone. HYG advertises around a 7% yield to maturity, attracting retail investors chasing yield. But the actual yield will be considerably worse because a number of bonds are expected be called and refinanced at lower yields ("yield to worst" is much lower than yield to maturity). Expected returns are shrinking as they did 7 years ago with structured credit.

HYG shares outstanding (Bloomberg)

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Gunning for yield and "quality" leaves little room for error

The global high yield bond issuance hit a record during the past quarter. With persistently low rates and tremendous demand for yield from mutual funds and ETFs, companies lined up to get ridiculously cheap financing.

Source: Credit Suisse

The chase for junk bonds however has been uneven. In the current environment investors want to make sure that companies have enough of an earnings cushion to withstand another shock. The demand for very high leverage companies has been weaker relative to the rest of the junk bond market. While the CCC issuance has been below previous years and below its weight in the HY index, the BB issuance was materially higher. Buyers have been looking for lower leverage (higher quality) companies that would survive a sharp increase in the debt to earnings ratio.

Source: Credit Suisse

This shift into "quality" resulted in lower yields for new issue BBs while higher yield for CCCs.

Source: Credit Suisse

This tells us that we continue to have strong demand for yield combined with concerns about "tail risk". But chasing new issue BB bonds yielding 6.3% could be a mistake. There is little upside on such bonds with treasury yields already at historical lows and spreads at fairly tight levels. Buying bonds like these simply leaves little room for error.

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The "irrational exuberance" of the credit markets

The corporate credit market rally is beginning to look silly. It is "irrational exuberance" at it's best.

The chart below shows speculative grade credit indices for HY bonds, leveraged loans, and emerging market bonds. We are now above the pre-Lehman levels and going higher today with the equity markets. If you invested in a diversified portfolio of HY bonds last summer, you would be up right now!



Companies that nobody would touch a few months are back are issuing paper. Blockbuster ($675 MM 12% notes) and Ford Motor Credit ($1 Billion 5-year notes, yielding as low as 9%) are some of the examples. Investment grade bonds are flying high as well. It's as though 2008 never happened.



All the new government served liquidity is making it's way into the market, chasing assets again. And there is no shortage of liquidity out there. The chart below shows the MZM measure of money supply. This measure includes all the cash instruments that are redeemable at par at any time: demand deposits, money funds, etc.



The risk of course is that at some point soon the Fed will start taking liquidity out, which will force interest rates up. And that can't be good for corporate credit markets in need of refinancing, as maturities loom.

US banks will roll the wall of maturing debt

From NYT DealBook

"Barclays Capital has analyzed financial company debt among United States institutions coming due over the next decade. During the rest of the year, for example, roughly $172 billion in debt will mature; in 2010, an additional $245 billion comes due. That amounts to about $25billion a month in debt rolling into a market with a shortage of buyers willing to invest in it."

Gretchen Morgenson (NYT) argues that this wall of debt with nearterm maturities will create severe problems for the US banking institutions.

The market however has so far discounted this as a non-event. Even with the full expectations of further asset write-downs. Here is an example: Citibank just issued $3 billion of 10-year unsecured debt. These bonds are NOT guaranteed by the FDIC.

The debt has traded to 103.8 since then. The yield is now under 8% (4.3% above treasuries). They originally sold $2 billion, but due to massive demand just sold another billion last week. Remember, this is Citi, a bank that was close to the brink 6 months ago.

Demand for bank paper (and other corporate debt) in the US is now massive. Foreign banks continue to issue debt (see our earlier post.) From Credit Agricole to Kommunalbanken Norway to Caisse Des Depots have recently sold bonds in dollars.

Unless the banking institutions Ms. Morgenson is referring to are too weak to issue debt now, they will either extinguish debt using deposit money or extend it now, while the window is open. Those too weak to do so are most likely the smaller banks that will get shut down by the FDIC anyway. Those that don't take advantage of this opportunity, probably deserve to meet their Darwinian fate for being too slow.