The Big Idea
Supply-side relative value
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As net supply goes, so goes spreads between different parts of the debt market over time. The last 12 months have offered a fine example. As Treasury supply has outstripped credit and MBS, risk assets have tightened. Other influences pitch in, but the supply trends put some guardrails on spreads.
Net new supply in Treasury debt has steadily topped net supply in risk assets for most of the last 12 months. The par balance of the Bloomberg Treasury index, for example, has climbed like clockwork while index investment grade and corporate debt and index MBS especially have lagged (Exhibit 1). Treasury debt has increased by 8.7%, investment grade corporate debt by 5.1% and high yield by 3.8% while MBS has come in flat. The flat balance in MBS in part reflects shifts in Ginnie Mae production from pools eligible for TBA delivery to custom pools excluded from the index. But Fannie Mae and Freddie Mac supply has been flat.
Exhibit 1: Growth in Treasury debt outstrips risk assets over the last 12 months
Source: Bloomberg, Santander US Capital Markets
Supply affects spreads between assets over time, and the relatively heavy supply of Treasury debt has arguably helped narrow the spreads of credit and MBS to the Treasury curve. Absolute option-adjusted spreads in MBS, investment grade and high yield are different enough to mask trends across assets, so it helps to index the spreads to some point in time and look at percentage changes. Using spreads a year ago as a starting point, OAS in risk assets have broadly narrowed while Treasury supply has outstripped risk supply (Exhibit 2). If spreads a year ago represent an indexed value of 100, OAS in risk assets finished last year around 80. MBS tightened in January on news of plans to have Fannie Mae and Freddie Mac buy a presumed additional $200 billion in MBS. Since January, spreads have widened with concerns about private debt and the US-Iran war but still stand below 100.
Exhibit 2: Treasury OAS has trended tighter in risk assets
Source: Bloomberg, Santander US Capital Markets
Other things have been going on besides shifts in debt supply, of course, most notably the steady decline in uncertainty around US trade policy after last April’s Liberation Day. That has reduced risk and encouraged tighter spreads. And spreads in one risk asset affect spreads in every risk asset, at least to the extent capital moves across markets to reflect relative value. These things have almost certainly contributed to tighter spreads, too.
Steady Treasury supply should keep subtlety pulling risk spreads in. The other notable dynamic is the gap between credit and MBS supply, where investment grade credit especially continues to outstrip MBS. Net Treasury supply in the first three months of this year grew at a compounded annual rate of 8.2%. But investment grade credit grew even faster at 11.2% while MBS dropped at an annual rate of 0.6%. MBS spreads, all else equal, should hold their ground or tighten disproportionately more than investment grade credit.
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The view in rates
Concern about oil prices and inflation make it hard for longer US rates to move down until there is more clarity on the length of the conflict in Iran and limits to the flow of oil through the Persian Gulf. There also are still signs that businesses are trying to pass through the costs of tariffs both old and new. Add to that the strong March payrolls and a decline in the unemployment rate, signals of some strength in the labor market. The front end of the curve is probably stuck around current levels. The Fed is almost certain to stay on hold through the end of Powell’s term as chair in May, and probably beyond that if oil is still recovering and if tariffs do keep inflation above target, and if labor is on the mend.
The 2s10s Treasury slope traded Friday at 50 bp, roughly flat over the last week, with 5s30s at 93 bp, steeper by 4 bp.
Key market levels:
- Setting on 3-month term SOFR traded Friday at 367 bp, nearly unchanged in the last five weeks
- Further out the curve, the 2-year note traded Friday at 3.84. The 10-year note traded at 4.34%
- The Treasury yield curve traded Friday with 2s10s at 50 bp, flat the last week. The 5s30s traded Friday at 93 bp, steeper by 4 bp
- Breakeven 10-year inflation traded Friday at 237 bp with 5-year forward 5-year breakeven at 216 bp, signals that confidence in the Fed target still holds. The 10-year real rate finished the week at 195 bp
The view in spreads
The US-Iran volatility is affecting all risk assets with corporate debt also wrestling with concerns around private credit and AI. Technicals are nevertheless constructive for both MBS and corporate debt. Fixed income mutual funds and ETFs are getting steady inflows, creating a steady bid for both spread assets. Fannie Mae and Freddie Mac continue to add to their mortgage portfolios, and insurers continue to issue annuities and buy corporate and structured credit. Supply in MBS is relatively low, although gross and net issuance in corporate debt is likely to contribute to softer spreads in that asset.
Investment grade credit still faces a challenge this year from a sizable 9% to 11% jump in net supply in part to fund AI infrastructure. That could outstrip growth in outstanding Treasury debt, widening the corporate-Treasury spread, and 2% growth in outstanding agency MBS, widening the corporate-MBS spread. Supply in MBS is even less after excluding Ginnie Mae custom pools, which are not included in the Bloomberg MBS index.
The Bloomberg US investment grade corporate bond index OAS traded on Friday at 83. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 116 bp. Par 30-year MBS TOAS closed Friday at 21 bp.
The view in credit
Bank lending to non-bank financial institutions, including private debt funds and business development companies, has expanded at an extraordinary pace in the last few years, raising the possibility that lending has outstripped experience and infrastructure for underwriting and monitoring. Bank regulators continue to focus on that category of lending, which could eventually tighten the private credit markets. But for now, credit metrics for NBFI lending are strong relative to traditional bank lending such as C&I. The balance sheets of smaller companies show signs of rising leverage and lower operating margins. Leveraged loans also are showing signs of stress, with the combination of payment defaults and liability management exercises, or LMEs, often pursued instead of bankruptcy, back to 2020 post-Covid peaks.
Consumer credit in the lowest tier of income continue to look vulnerable, and cuts to government programs this year should keep the pressure on.
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