The outlook appears favorable for spread product in the next three to six months, according to JPMorgan research strategists speaking last Wednesday at the firm's investor conference held at the corporate headquarters in New York. In the second half of 2002, however, Treasury yields may rise rapidly as the Federal Open Market Committee takes a more aggressive credit-tightening stance, reversing gains made early in the year.
Agencies, mortgages and ABS are all favored and should outperform swaps, they said, although swaps will tighten versus Treasury benchmarks, especially in the five-year area, where Treasury supply is expected to grow. While most ABS sectors can not tighten much, they are seen as a smart defensive play, while some opportunities still lie in off-the run names and sectors.
MBS strategist Joan Rogers fully endorsed the mortgage market as a strong relative-value play for the first half of the year, as strong performance has been the case following the past refi waves of 93, 95 and 98. She added that mortgages are a good choice right now, given declining originations and easing volatility.
Seasoned paper, 98 vintage 6.5s for example, are more insulated from prepayment impact as the change in jumbo-loan qualifications and low coupon collateral should bolster these deals. MBS, she added has the potential for the most significant tightening this year.
While conceding that ABS is viewed as a defensive play by investors, researcher Chris Flanagan reiterated there is yield in off-the-run names, sectors and down in credit, although there is better value in some unsecured corporate paper for the risk. Because yields are so tight in some areas of the market, most feel that the only play is for liquidity, Flanagan conceded, but added that there is value in second- and third-tier names in all sectors, as well as in the entire home-equity sector and CDOs, which currently trade at distressed levels.
In HELs, for example, Flanagan said, "You don't have to reach far for yield," noting paper from benchmark issuers Chase Funding, GMAC-RFC and Saxon all offer decent spread. Also, the evolution of the NIM allows issuers short-term liquidity, which simultaneously nullifies residual writedowns that had plagued the sector, he added.
And in other
Swap spreads will remain directional with Treasuries as in 2001 but to a lesser extent, according to Terry Belton, JPM's global head of derivatives strategy. The anticipated increase in five-year Treasury volume will help swaps, as will an expected flattening of the Treasury curve, he said. The swap market has yet to price in the improving credit situation, he added, which will also help their performance.
GDP is expected to grow in 2002, and the correlation between economic growth and swap tightening was pegged at 2.3 basis point tightening for each 1% increase in production. The five-year sector is once again most favored because of the increasing deficit as well as yield curve flattening. JPM targets five-year swaps at a tight level of 60 basis points over Treasuries by mid-year, in from Thursday's mid-market of 68.5 basis points.
"Swaps are a good short (position) versus spread product," Belton said. "While they will tighten they won't come in as much."
In the agency debt, Hussein Malik, JPM's head of U.S. Treasury and agency strategy, predicted about a 10-15 basis point narrowing in spreads in the coming three months. He targeted 10-year agency spreads at about 60 basis points over Treasurys; in comparison Freddie Mac priced $7 billion of 10-year debt at a spread of 72 basis points over Treasurys. Malik added that there is strength in 10-year callables as implied volatility is near all time highs now and will likely decrease in the coming six months. Accordingly, Malik recommended an overweight in 10-year-non-call-three agencies.
The only fixed-income sector with a semblance of negativity was the high-grade corporate debt market, which has experienced high profile blowups and suffers from earnings-driven headline risk. William Cunningham, head of high-grade research, said that his market was at the cusp of recovery from a three-year skid, if management remains on the fiscally responsible path which it seems to be.
The mistakes of levering up to boost stock prices during the dot-com boom had taken a toll on the old-economy firms that make up the IG sector and after a volatile 2001, things may be looking up. "If it is true that the Fed is done easing, and it looks that way, we have made it through the worst," he said. - KD/TG