The Big Idea

Reading the trends in debt security supply and demand

Steven Abrahams | September 20, 2024

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.

The rate of growth in outstanding US debt securities dropped in the second quarter, led by declining growth in Treasury securities and in corporate, structured credit and foreign debt securities. The clearest demand came from P&C insurers and ETFs, among others. Over coming quarters, watch for the Treasury market to retake the lead in growth and for banks to show improving investment appetite.

A snapshot of debt securities supply

Repricing and net issuance lifted the value of US debt securities by $333 billion or 0.55% in the second quarter of this year, according to the recently released Financial Accounts of the United States. That brings the total value of outstanding US debt securities to $60.3 trillion—or roughly 40% of the global total, based on figures from the Bank for International Settlements.

Corporate, structured credit and foreign securities led absolute growth at $127 billion through the quarter while state and local municipal securities led percentage growth at 1.11% (Exhibit 1). Treasury debt, which has led absolute and percentage growth for most of the last few years, lagged the nominal pace in corporate, structured credit and foreign debt and fell to fourth place in percentage growth. Agency and GSE-backed securities grew in absolute and percentage terms after no growth in the first quarter. And the commercial paper market, after growing to start the year, fell from March through June.

Exhibit 1: Credit and muni securities led growth in debt securities in 2Q2024

Source: Financial Accounts of the United States, Santander US Capital Markets

The relative pace of supply across major types of debt securities matters for relative spreads, at least assuming steady investor preferences. Faster growth in credit and agency debt and MBS could eventually put pressure on spreads relative to Treasury debt, although it would be hard to tie these relative supply results directly to the recent spreads in credit and MBS.

The latest pace of supply in available debt securities marks a slowdown in all types of debt from recent quarters except for muni and agency and GSE-backed issues. Total debt securities have grown at a compounded quarterly rate of 1.27% since the first quarter of 2023, for instance, a sharp contrast to the latest 0.55% pace. Treasury debt has grown at a quarterly compounded rate of 2.03%, also sharp contrast to the latest 0.35%.

Exhibit 2: Growth slowed in 2Q2024 except for muni, agency securities

Source: Financial Accounts of the United States, Santander US Capital Markets

A snapshot of debt securities demand

As for demand, the Fed numbers show households leading the way with $276 billion in portfolio growth (Exhibit 3). However, the household category in the Fed report includes hedge funds, and the category also is used to absorb other changes in debt securities balances that the Fed cannot account for elsewhere. That makes household growth hard to interpret.

Exhibit 3: A snapshot of quarterly growth in investor debt securities holdings

Source: Financial Accounts of the United States, Santander US Capital Markets

Among more reliably measured investor categories, P&C insurers added a leading $96 billion in securities and grew their outstanding holdings by 6.8%. Foreign portfolios, ETFs, state and local government portfolios also showed strong growth. And life insurers showed reasonable growth, too.

The latest Fed numbers continued to show the Fed’s own portfolio shrinking, but also showed lower balances in money funds, which contrasts with reports from the Investment Company Institute and other tracking mutual fund balances. However, the Fed’s money fund numbers are likely an anomaly since money funds have grown rapidly since June.

The newest Financial Accounts also showed lower debt securities balances at US banks, consistent with the Fed’s H.8 reporting. However, bank holdings of MBS and other securities have grown since June.

Netting supply and demand

The most important supply trend to watch coming out of the second quarter is the rate of growth in credit and agency debt securities relative to Treasury debt. If risk assets continue growing faster than the Treasury market, then risk spreads should come under pressure. However, the Congressional Budget Office continues to project that Treasury debt will grow faster than US GDP, and it is unlikely that credit and agency debt can outpace GDP in the long run. Look for growth in Treasury debt to retake the lead in coming quarters.

As for demand, the most important trend to watch there is in bank demand. Bank demand has already improved in the third quarter in all likelihood because of tighter lending standards and concerns about the slowing economy. As the second largest holder of debt securities behind the Fed, a small change in bank demand can go a long way. Look for improving bank demand in coming quarters.

Another demand trend to watch is in mutual funds and ETFs. Those portfolios have seen reliably inflows all through 2024, and the latest drop in interest rates and posting of good total returns should keep inflows coming. That likely bodes well for Treasury, credit and agency debt, which are all important components of most broad fixed income market indices.

* * *

The view in rates

Even after the Fed’s 50 bp cut, the market continues to take an aggressive view of the Fed’s likely path, which argues for a neutral position on rates for now. As of Friday, fed funds futures priced in another 74 bp of easing this year and nearly 200 bp through 2025, implying fed funds at the end of next year around 2.80%. As fed funds head toward the neighborhood of 3%, the front end of the yield curve should drop to reflect the lower policy rate with the 10-year and longer end of the curve moving much more slowly if at all. Opportunities to outperform the broad market have shifted from rate position to spread positioning.

Other key market levels:

Fed RRP balances closed Friday at $339 billion, up $54 billion in the last week. Since the Fed dropped policy rates by 50 bp on September 18 and set the RRP rate at 4.80%, balances have jumped in all likelihood because T-bill yields have dropped well below RRP yields.
Setting on 3-month term SOFR closed Friday at 469 bp, down 25 bp on the week.
Further out the curve, the 2-year note closed Friday at 3.59%, up 2 bp in the last week. The 10-year note closed at 3.74%, up 9 bp in the last week.
The Treasury yield curve closed Friday afternoon with 2s10s at 15 bp, steeper by 8 bp in the last week. The 5s30s closed Friday at 59 bp, steeper by 4 bp over the same period
Breakeven 10-year inflation traded Friday at 215 bp, up 7 bp in the last week. The 10-year real rate finished the week at 159 bp, up 2 bp over the last week.

The view in spreads

Implied rate volatility often drops after an FOMC meeting, and vol played its part this time around, too. That is a marginal plus for spreads in risk assets. However, not all risk assets are the same. A slowing economy is raising fundamental concerns about credit, although credit still has support from a strong bid from insurers and mutual funds. Bank, mutual fund and foreign demand is helping MBS spreads by offsetting the continuing exit of the Fed. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risky and riskless assets.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 91 bp, tighter by 7 bp on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 122 bp, tighter by 1 bp in the last week. Par 30-year MBS TOAS closed Friday at 31 bp, wider by 4 bp over the last week.

The view in credit

Even though credit has widened lately, the fundamentals still look relatively strong. The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Rising unemployment should put pressure on consumers, but high levels of home equity and investment appreciation should buffer the stress. Other parts of the market funded with floating debt continue to show weakness. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. 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 and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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