Fed Spends 40% on Benchmarks as Newest Prove Cheapest

Fed Spends 40% on Benchmarks
The Federal Reserve in Washington. Photographer: Joshua Roberts/Bloomberg

The Federal Reserve’s Treasury purchases already have succeeded in driving investors to junk bonds and stocks. Now, policy makers are focusing on benchmark government securities, helping contain rising yields that set rates on everything from corporate debt to mortgages.

More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers’ holdings of Treasuries to the lowest since November 2009.

“They’re getting all the bang for their buck that they can” by purchasing so-called on-the-run bonds, said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, which oversees $22 billion. “When you’re the largest buyer out there, when you replace China in terms of the size of your holdings of Treasury securities, that will happen.”

The Fed purchases are helping keep a lid on borrowing costs for companies and homebuyers as the economy recovers. Yields on corporate bonds have averaged about 4.84 percent since the buying began in November, below the 5.48 percent for all of 2010, according to Bank of America Merrill Lynch indexes. The average rate on a 30-year fixed mortgage has been 4.61 percent, in line with 2010’s 4.69 percent and lower than the 5.93 percent of the past decade, according to Freddie Mac in McLean, Virginia.

Maintaining Demand

Quantitative easing has boosted demand for Treasuries as President Barack Obama’s budget deficits exceed $1 trillion, adding to the nation’s $8.96 trillion in marketable debt. Investors bid $3.04 for each dollar of bonds sold in the government’s $178 billion of auctions last month, the most since September, according to data compiled by Bloomberg.

Yields on Treasuries of all maturities fell to an average of 1.88 percent in January, the first monthly drop since October, Bank of America Merrill Lynch index data show. The benchmark 10-year note may decline to 3.52 percent at the end of the second quarter from 3.64 percent Feb. 4, based on the median estimate of 76 economists, strategist and analysts surveyed by Bloomberg. Current rates compare with the average of 5.26 percent during the past two decades. The rate rose three basis points to 3.66 percent at 9:06 a.m. in New York.

Weekly Slump

The 10-year note yield increased 31 basis points last week, according to BGCantor Market Data. The price of the 2.625 percent security due November 2020 fell 2 15/32, or $24.69 per $1,000 face amount, to 91 3/4.

Since Nov. 3, when Fed Chairman Ben S. Bernanke announced the plan to buy government debt to keep the economy from falling into deflation, 10-year yields have increased about one percentage point as expectations for inflation rose. The purchases and signs that the economy is recovering have reduced demand for the safety of government debt in favor of riskier assets and the Standard & Poor’s 500 Index has risen 9.4 percent.

Speculative-grade corporate bond yields fell to 4.68 percentage points, or 468 basis points, more than Treasuries last week, the least since November 2007 and down from 6.22 percentage points in November, according to Bank of America Merrill Lynch index data. Debt rated lower than Baa3 by Moody’s Investors Service or less than BBB- by Standard & Poor’s is below investment grade, or junk.

Biggest Owner

The Fed became the biggest owner of U.S. government debt in November, when holdings reached $896.7 billion, overtaking China’s $895.6 billion, according to Treasury and central bank data. It purchased $288 billion since Nov. 12, mostly from dealers, reducing Wall Street’s holdings of long-term Treasuries to a so-called net short position of negative $22.3 billion in the week ended Jan. 19.

That means prices shown to the Fed when it buys will continue to increase, according to Credit Suisse Group AG, one the 20 primary dealers that trade directly with the central bank.

Now, the Fed is turning to benchmark bonds for quantitative easing because older, or off-the-run, securities are becoming too expensive as measured by the bid-ask spread showing the difference between the lowest price for securities offered for sale and the highest bid.

The difference between the prices at which investors are willing to buy and sell older five-year notes due February 2016 has widened to 1.0833 basis points since Nov. 3, according to Bank of America. In the five months before the Fed announcement the spread was 0.97 to 0.99 basis point. Every 0.1 basis point on $600 billion of bonds would save the Fed about $6 million.

Deficits, Inflation

Creating more demand for newer bonds gives Wall Street an added incentive to buy at government sales, helping keep benchmark yields in check.

“Dealers are more likely to bid more aggressively at Treasury auctions if they can sell to the Fed in the not-so-distant future,” strategists at Bank of America Merrill Lynch said in a Jan. 31 note to investors.

While the Fed’s purchases have helped boost confidence, bigger deficits and speculation that inflation may accelerate have sent yields higher, said Larry Dyer, a U.S. interest-rate strategist in New York with HSBC Holdings Plc’s HSBC Securities unit. Treasuries lost 3.7 percent since the beginning of November, including reinvested interest, after returning 8.59 percent in the first 10 months of 2010, Bank of America Merrill Lynch data show.

“The Fed has monopoly control over front-end rates,” Dyer said. “But in bringing down long-term interest rates, the Fed is having a much tougher time.”

Yield Curve

Bernanke has kept the target interest-rate for overnight loans between banks in a range of zero to 0.25 percent since December 2008. The difference between yields on two- and 10-year yields rose to 2.89 percentage points last week, above median of 1.81 percentage points the past decade. A widening yield curve has historically been a sign that investors anticipate a strengthening economy.

The Institute for Supply Management said Feb. 1 that its factory index accelerated in January to the fastest pace in more than six years and the Labor Department said Feb. 4 the U.S. unemployment rate dropped to 9 percent in January from 9.4 percent in December as job creation slowed amid winter storms.

Optimism on the outlook for the economy allowed companies in the U.S. to sell $159 billion of bonds last month, a record for January, according to data compiled by Bloomberg.

Goldman Sachs Group Inc., the fifth-biggest U.S. bank by assets, sold $3.5 billion last week in its largest dollar-denominated issue without government backing since 2004.

Shrinking Spreads

The bank’s new securities included $2.5 billion of 3.625 percent debt maturing in 2016 that yields 158 basis points more than similar-maturity Treasuries, Bloomberg data show. In July, Goldman Sachs issued $2.25 billion of 5-year, 3.7 percent notes that paid 205 basis points more than benchmarks.

Microsoft Corp. issued $2.25 billion of bonds, according to Bloomberg data. The Redmond, Washington-based company’s $750 million of 2.5 percent, 5-year notes were priced to yield 38 basis points more than Treasuries, compared with 40 basis points on its $1.75 billion sale of 1.625 percent, 5-year debt on Sept. 22. The new spread was the narrowest since Gillette Co. sold $300 million of 2.875 percent, 5-year debentures on March 4, 2003, at 37.5 basis points.

“Buying the newer issues has a more-direct impact on yield targeting and the Fed’s goal of keeping rates low within a range,” said George Goncalves, head of interest-rate strategy at Nomura Holdings Inc., another primary dealer. “The Fed has taken some of the liquidity out of the market, which gives their purchases more impact.”


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