Treasury Two-Year Notes Attract Record Direct Demand

Treasuries rose as concern the U.S. economic recovery is faltering drove record demand from a group of investors that includes pension funds and insurance companies at the government’s auction of $35 billion of two-year notes.

Direct bidders, or institutional investors outside the 21 securities firms required to participate in U.S. debt auctions, bought 38.2 percent of the notes. That compares with an average of 12.2 percent at the past 10 auctions. The notes were sold at a yield of 0.295 percent, compared with a forecast of 0.304 percent in a Bloomberg News survey of seven of the Federal Reserve’s primary dealers.

“The general backdrop is all bullish for the bond market, with the fiscal cliff approaching, continued uncertainty in Europe, the threat of slowing global growth and the U.S. election,” said Scott Graham, head of government bond trading at Bank of Montreal (BMO)’s BMO Capital Markets primary dealer unit in Chicago. “The uncertainty is keeping Treasuries well bid.”

Ten-year note yields fell six basis points, or 0.06 percentage point, to 1.76 percent at 5 p.m. New York time, according to Bloomberg Bond Trader data. The prices of the 1.625 percent note due in August 2022 rose 16/32, or $5 per $1,000 per face value, to 98 25/32.

Yields on the current benchmark 0.25 percent two-year notes due in September 2014 fell two basis points to 0.29 percent. The notes sold today mature in October 2014 and yielded 0.3 percent in when-issued trading prior to the auction.

Corporate Earnings

The bid-to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was 4.02, compared with an average of 3.73 for the past 10 sales.

Treasuries advanced earlier as lower-than-forecast results from global corporations cast doubt about the strength of the economic recovery. The Standard & Poor’s 500 Index declined for the third time in four days after disappointing earnings from companies from 3M Co. to DuPont Co.

“We are seeing risk-off markets and safe haven buying as global equities are down with global economic concern and uncertainties continuing,” said Larry Milstein, managing director in New York of government-debt trading at R.W.Pressprich & Co., a fixed-income broker and dealer for institutional investors.

The Fed has been replacing $267 billion of short-term debt in its portfolio with longer-term Treasuries.

Quantitative Easing

“We are getting near the end of Operation Twist, and the amount of two-year notes that the Fed can sell is running out at a time when liquidity is still in demand,” BMO’s Graham said.

At its last meeting, which ended on Sept. 13, the Fed announced it will buy $40 billion of mortgage-backed securities a month to put downward pressure on borrowing costs. It also said it will probably keep its target for overnight borrowing between banks near zero at least through the middle of 2015.

All 21 primary dealers expect the Fed to expand stimulus measures before year-end to include purchases of government securities, according to a survey of the bond traders last week by Bloomberg News. The central bank is also swapping short-term Treasuries in its holdings for longer-term securities to cap yields as part of its efforts to spur the economy.

Indirect bidders, an investor class that includes foreign central banks, purchased 33.5 percent of the two-year notes, compared with an average of 30.2 percent for the past 10 sales.

Two-year notes have returned 0.1 percent this year, compared with a 1.5 percent gain by Treasuries overall, according to Bank of America Merrill Lynch indexes.

Spanish Downgrades

The Treasury will auction $35 billion of 5-year securities tomorrow and sell $29 billion of 7-year debt the next day.

Treasuries were also buoyed after Moody’s Investors Service cut the ratings of five Spanish regions late yesterday and the nation’s economy shrank for a fifth quarter, adding pressure on Prime Minister Mariano Rajoy to seek European aid. Spain’s 10- year bond yield rose 13 basis points to 5.62 percent.

The difference between U.S. five-year interest-rate swaps and same-maturity Treasury yields narrowed to as little as 9.8 basis points, the least since March 2010.

Investors use swaps to exchange fixed and floating interest-rate obligations. The spread between the fixed component and the Treasury rate narrows as demand for higher- yielding assets increases.

“The Fed’s pledge to keep rates low still stands, which continues to buoy demand,” said Justin Lederer, an interest- rate strategist at primary dealer Cantor Fitzgerald LP in New York.

To contact the reporters on this story: Cordell Eddings in New York at ceddings@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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