The Big Idea

Shifting share in debt markets

| September 15, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Credit markets remain the least subject to the changes in policy and regulation that shape demand for Treasury debt and agency MBS. The latest Fed numbers show foreign and US insurers along with mutual funds continue to hold outsize shares of corporate and structured credit. And changes in share of credit tend to be modest. The Treasury market remains dominated by foreign central banks and the Federal Reserve. And the agency MBS market remains in the grip of US banks and the Federal Reserve. Policy and regulation matter, and it is still in play.

US Treasury debt

Foreign portfolios remained the largest holder of Treasury debt with nearly 30% of outstanding market value at the end of the second quarter, according to the Fed’s Financial Accounts of the United States, half of that at foreign central banks. Foreign share rose in the first quarter but fell in the second and finished June down 0.05%. With the US running a current account deficit of around 3.3% of GDP, foreign portfolios have plenty of dollars to invest and should remain important Treasury players. Outside of the UK, US Treasury yields remain the highest among global government benchmarks and should continue drawing good foreign interest.

Exhibit 1: Fed and bank share falls, households and other pick up the slack

Source: Federal Reserve Z.1, Santander US Capital Markets

The Fed came in second through June, holding slightly more than 18% of outstanding market value. But Fed share has dropped 2.22% through June with QT letting $65 billion of Treasury debt roll off monthly. QT looks likely to run at least for another year.

Other large Treasury investors have mixed incentives to add exposure. Federal government retirement funds, at more than 10% through June, hold mainly nonmarketable debt and have cut exposure by 0.46%. Households, which includes nonprofits and hedge funds, holds 9% and saw share rise 2.35% year-to-date; this category often serves as spillover for balances not captured elsewhere and is subject to large revisions. Mutual funds hold more than 5% of the market and saw share drop 0.21% through June; mutual funds should continue cutting Treasury exposure to add better relative value in MBS and credit. Money market funds hold around 5% and saw share through June rise 0.52%, mainly adding Treasury bills as cash poured in from banks.

US agency debt and MBS

The market for agency debt and MBS keeps wrestling with falling demand from its largest investors—banks and the Federal Reserve. The Fed reports both assets together, but MBS dominates. US banks at the end of June held nearly 26% of outstanding market value, down 1.1% for the year. As Tom O’Hara notes, banks may only return to the securities market after the Fed stops tightening, regulatory uncertainty clears and only if loan demand ebbs. The Federal Reserve at the end of June held nearly 20% of the sector balance, down 1.5% for the year. Fed QT is likely to go on well into next year with MBS balances continuing to fall.

Exhibit 2: Fed and bank share falls, others pick up the slack

Source: Federal Reserve Z.1, Santander US Capital Markets

Demand from other investors still looks mixed. Foreign investors, with nearly 12% of holdings through June, is up for the year by 0.10%. Households, still a catch-all category subject to sizable revisions and hard to predict, finished June holding more than 11%, up for the year by 1.3%. Money market funds finished June holding nearly 7%, up 1.4% this year, although almost all of that is in agency discount notes. Mutual funds came in through June holding around 5%, up on the year by 0.4%. With MBS showing good relative value to Treasury debt and some parts of the corporate market, mutual funds should continue adding to their MBS balances.

Corporate and structured credit

The corporate market and the market in structured credit continues to be dominated by private investors, making it less subject to significant changes in demand from public or quasi-public portfolios. Foreign insurers, captured through the Fed’s Rest of the World category, along with US life insurers and mutual funds hold outsized shares of outstanding market value. Foreign portfolios held more than 25%, flat on the year. US life insurers held nearly 19%, up 0.1% on the year. And mutual funds held 15.4%, down 0.4% on the year—likely reflecting rotation into MBS. Notably, no holder of corporate or structured credit has changed share so far this year by more than 0.5% (Exhibit 3).

Exhibit 3: No holder has changed share of credit this year by more than 0.5%

Source: Federal Reserve Z.1, Santander US Capital Markets

As Dan Bruzzo describes, parts of the corporate market look ripe for rotation, so presumably investors in corporate and structured will start considering their options there. Structured credit broadly looks wide to corporate credit, so some investors will rotate there, too. Others may choose to continue rotating out of corporate credit and into MBS.

* * *

The view in rates

OIS forward rates broadly see a limited chance of more hikes from the fed and roughly steady rates through March. The same forwards then anticipate 76 bp of cuts from March to December 2024. The market is probably missing one more hike in November. Other than the missing hike, the market at this point is pricing a fair path. The Fed may hold rates high into July next year and then cut 100 bp by December, but that amounts to a small difference in the long run. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.

Other key market levels:

  • Fed RRP balances closed Friday at $1.40 trillion, down $124 billion in the last week as money leaves for the Treasury bill market
  • Setting on 3-month term SOFR traded Friday at 541 bp, unchanged in the last week
  • Further out the curve, the 2-year note closed Friday at 5.03%, up 4 bp from mid-August. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.33%, up 7 bp in the last week. Much of the rise in 10-year yields came after late July hints of a shift in Japan’s yield curve control and the Treasury announcement of heavy supply ahead. With inflation likely to drift down and growth likely to slow through this year and next—shaping the Fed path—fundamental fair value on the 10-year note for now is closer to 3.50%.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -70, steeper by 2 bp in the last week. Expect 2s10s to reflatten beyond -100 bp again as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s closed Friday at -4 bp, steeper by 2 bp in the last week.
  • Breakeven 10-year inflation traded Friday at 234 bp, unchanged on the week. The 10-year real rate finished the week at 198 bp, up 5 bp on the week.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 146 bp, unchanged on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 166 bp, unchanged on the weekt. Par 30-year MBS TOAS closed Friday at 64 bp, wider by 6 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile in the last month but trending wider.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. At this point, mainly ‘B’ and ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.

Steven Abrahams
1 (646) 776-7864

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