–Overweight in Investment Grade Corporates

By Yali N’Diaye

WASHINGTON (MNI) – However you look at agency mortgage-backed
securities, they are expensive and it is better to reduce exposure to
such debt, Morgan Stanley Smith Barney Chief Fixed Income Strategist
Kevin Flanagan tells Market News International.

And that’s without considering the Federal Reserve no longer buying
agency MBS or uncertainties about asset sales down the road.

For those investors looking to buy agency MBS anyway, they are
better off avoiding the political uncertainty surrounding the future of
Fannie Mae and Freddie Mac by sticking to the front end of the curve —
under the two-year area.

Instead, against the backdrop of rising interest rates to come and
an economic recovery, Flanagan favors investment grade corporates, which
provide better insulation against rate increases than more
interest-sensitive sectors such as Treasuries and agencies.

While Flanagan recommends staying within the 2- to 5-year sector
for Treasuries and even high yield, not only would he overweight
investment grade corporates but he’d also go out the curve. Not too
much, however, as Flanagan says he would not go beyond the 8-year

Overall, he said, the biggest risk in fixed income markets right
now is interest rate risk, closely followed by sovereign risk.

On the sovereign side, U.S. risk escalated after the health care
reform was signed, he commented. “While we don’t see any significant
issues or downgrade for U.S. sovereign debt, still there is a lot of
fiscal challenges among the developed world,” Flanagan said.

This partly explains why the 5-year and 7-year note auctions
disappointed last week, he continued.

And as sovereign risk is receding in the euro zone after a rescue
plan was approved for Greece, focus on the U.S. market is likely to
return to actual fundamentals.

As long as the outcome for Greece remained uncertain, sovereign
risk in the euro zone has resulted in flight-to-quality buying of
Treasuries despite the very large U.S. debt-to-GDP ratio.

So in a perverse way, removing EMU sovereign concerns “removes a
layer of support for Treasuries” and allows investors to focus more on
the “true underlying fundamentals,” Flanagan said.

And U.S. fundamentals are not too supportive, given the
unsustainable fiscal deficits, higher debt burdens, record coupon supply
this year and the economic recovery.

Flanagan ruled out a double-dip recession, with the U.S. GDP likely
to grow at a pace of about 3%.

“The market needs to recalibrate itself for that kind of scenario,”
he said.

The 3% recovery is weaker than the 5% to 6% that would typically
take place following such a deep recession, Flanagan said, which is due
to the unemployment rate that is expected to stay elevated.

In fact the coming employment report might just illustrate that
view. Analysts’ expectations in a MNI survey center around a net 200,000
increase in March nonfarm payrolls following a 36,000 decline in
February, improved weather and Census hiring expected to add to
payrolls. However, the unemployment rate is seen stable at 9.7%, with
some even expecting an increase to 9.9%.

“The labor market situation is going to remain sticky for quite
some time,” Flanagan predicted.

So the recovery certainly won’t come from the consumer side, he
continued, although the Conference Board Tuesday reported a
stronger-than-expected improvement in consumer confidence in March.

However, the March gain in U.S. consumer confidence is not
significant and does not by itself point to a big gain for March
payrolls, according to Conference Board survey chief Lynn Franco told
Market News International in a separate interview.

Rather, the recovery will come from manufacturing, exports,
inventory adjustments and government spending, he anticipates.

And as the economy recovers, interest rates will rise and the yield
curve will likely steepen further.

Against this background, Flanagan favors the 2- to 5-year sector,
especially for Treasuries, agencies, and high yields.

The only part of the fixed income he would move further out the
curve is investment grade corporates, where he would invest through the
8-year area, as investment grade corporates provide more insulation from
higher yields than Treasuries.

Within the agency sector, in fact, he would not go out to five
years — at least for Fannie Mae and Freddie Mac MBS — where investors
are better off staying under the two-year sector.

The Treasury has repeated it will backstop Freddie Mac and Fannie
Mae through 2012, but beyond that, it is total uncertainty.

Monday evening, Treasury Secretary Timothy Geithner repeated his
declaration of complete support for Fannie and Freddie.

“I’ll say what I said then at the hearing and I’ll never change
this basic view, which is that we have made it clear we will provide
whatever capital, whatever amount of capital is necessary, to make sure
that those two institutions can meet their obligations, past and

He added, “We’re not going to go back to the system the way it
was,” doing little to lift the uncertainty about the future of the two
mortgage giants.

Given the political risk surrounding Fannie and Freddie down the
road, “you shouldn’t be moving out on the curve because that’s where the
uncertainty will come more into play,” Flanagan said.

And buying beyond the 2-year sector would present a double risk of
underperformance for investors: from a rate aspect and from a credit
aspect, “just the uncertainty, not knowing where Fannie and Freddie is
going to be 5-10 years from now.”

Even with the political risk aside, agency MBS is currently
expensive, which does not make them attractive.

“By any metric that you use when looking at MBS valuation they’re
expensive,” Flanagan said.

And that’s also without considering the Federal Reserve no longer
buying agency MBS or questions about asset sales down the road.

“When you throw that into the mix,” he said, “you could see how it
could be a challenging environment for mortgage-backed over the next
couple of quarters.”

The Fed agency MBS buying program officially ends this week.

Flanagan does not expect the so-called “cliff effect” when the Fed
stops buying agency MBS, as some “natural buyers” such as banks might

That said, not only is he concerned about their valuation, but also
about the impact of the rising Treasury yields on the MBS market, as he
expects the 10-year Treasury yield to rise to at least 4.50% this year.

The 10-year yield was trading around 3.87% midday Tuesday. While
this is still low, it has been steadily rising since a low point of just
over 2% at the end of December 2008.

“So in our portfolios, our allocations tend to be neutral at best”
for agency MBS, Flanagan said, advising his clients to reduce positions
in agency MBS.

And the debate about asset sales, which is a natural debate “that’s
going to go on within the Fed for a while,” only argues in favor of
taking profits or reduce positions on agency MBS.

“Regardless of whether the Fed actually pulls the trigger, if this
becomes a public debate about the timing of these asset sales,” it will
become a “significant headline risk” for MBS investors, Flanagan said.

He expects the Fed to eventually sell its assets, but not within
the next three to six months.

Last week, Philadelphia Fed President Charles Plosser said in an
interview with the Wall Street Journal, “Given the market functioning, I
don’t anticipate that selling MBS at a reasonable pace, that that’s
going to have a tremendous impact on mortgage rates per se.”

But the Fed is in a difficult position for now, Flanagan said,
noting “there is still this huge shadow inventory” of potential
foreclosed homes that are going to hit the market at some point.

“To me the Fed would be up against it if they actually started at
the same time to sell some of these MBS.” So, “we are not there yet,”
although the topic of asset sales will likely “heat up” toward the end
of this year.

For now, however, it appears that selling assets is the minority
view within the Fed. That said, with Fed Chairman Ban Bernanke changing
tone, “you wonder if some of the sentiment is beginning to shift among
the voting members themselves,” Flanagan said.

** Market News International Washington Bureau 202-371-2121 **

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