NEW YORK, Nov 10 (Reuters) - The Federal Reserve 's planned bond purchases will reduce dollar-denominated debt supply next year and could drive corporate and other credit spreads tighter as well as push U.S. Treasury yields back to historical lows.
Fixed income and other financial markets have been roiled in the past 24 hours by worries the Fed will succeed only too well at its goal of fueling inflation. However, the new round of Fed buying has not even begun.
In total, the Fed said last week it would buy more than $800 billion in Treasuries, including re-investment of maturing debt in its existing portfolio. The plan is aimed at rekindling economic growth by driving down yields and encouraging investments that will spark private lending.
Analysts at banks including Credit Suisse , JPMorgan and RBS (LSE: RBS.L - news) Securities predict the purchases will cause the overall supply of fixed income assets available to investors to dwindle.
When accounting for the Treasuries purchases, the banks predicted the overall supply of fixed income assets, which includes corporate bonds, municipal, mortgage-backed and other debt, will fall by more than 40 percent in 2011, even as demand for fixed income remains strong.
RBS expects net supply of high quality dollar-based fixed income assets in 2011 to total around $1.35 trillion, which after accounting for Fed purchases of $660 billion would leave $690 billion for other buyers. Buying by foreign central banks, however, may tie up the bulk of remaining purchases, it said.
"You've taken out all the supply of high quality dollar assets before private investors have even opened the door," said John Briggs, U.S. interest-rate strategist at the firm.
"This is what the Fed wants, to drive Treasury yields lower and drive investors to alternative assets. There's not enough supply to go around with the Fed purchases so investors need to reach for yields," said Briggs, in Stamford, Connecticut.
Foreign official institutions may buy around $540 billion in Treasuries next year, RBS said. In that case only $150 billion would be available to other investors, it said.
SUPPLY TO SINK
Net issuance of other fixed income asset classes is unlikely to offset the Treasury purchases.
Supply of U.S. agency mortgage debt is expected to jump to $559 billion, after seeing a loss of $86 billion in 2010. However this growth will be more than offset by the drop in Treasury and US agency supply, Credit Suisse said. Sales of agency mortgages may rise though net issuance of corporate, asset-backed and municipal debt is also likely to be largely unchanged, it added.
JPMorgan projects that net issuance of Treasuries, high grade and high yield bonds, build America municipal sales, emerging market corporates and structured assets will drop 40 percent to $600 billion in 2011, from around $1 trillion in 2010. This figure has dropped from $1.9 trillion in 2007, the bank said.
Companies are expected to continue to be among the largest gainers from the Fed's purchases, as dwindling supply will allow them to sell debt at even lower costs.
"In the short term the supply of bonds is going to dwindle and the yields are going to go down and the price of credit for issuers is going to go down," said David Rubenstein, chief financial officer and general counsel at credit hedge fund BlueMountain Capital Management in London. "It becomes an artificially cheaper source of capital than it otherwise would be."
Loose credit markets, however, may encourage companies to increase leverage in order to favor other investors such as shareholders and allow some companies to access capital that they would not otherwise have access to without the stimulus.
"At some point the artificial price support will run out and the companies that couldn't otherwise have raised debt at those coupon levels are going to suffer and their bonds are going to suffer," said Rubenstein. "The risks are that when the stimulus goes away, what's going to happen to the price of credit at that time?"
TREASURY YIELDS TO STAY LOW
The Fed's purchases are also likely to keep a cap on short to intermediate maturity Treasury yields, and could send some yields even lower as investors extend duration.
"A lot of money managers are already underweighting the front end of the curve, very few money managers are fully invested in two- to three-year maturities because the yield there is so low it just doesn't make sense," said Igor Cashyn, Treasury and TIPS analyst at Morgan Stanley (NYSE : MS - news) in New York.
RBS and Morgan Stanley are among banks that project benchmark 10-year Treasury yields will drop to around 2.25 percent, from their current 2.6 percent. Credit Suisse expects the notes will trade in a range between 2.25 or 2.8 percent.
"It's difficult to be short in this environment, that's the key takeaway. Its difficult to be short Treasuries with the Fed buying a huge bunch of them," said Ira Jersey, interest rate strategist at Credit Suisse in New York.
Source Yahoo! Finance
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