Federal Agencies and Supranationals

Dan Krieter, CFA [email protected] 312-845-4015

March 20, 2019 0 Strategy Agency Debt Declining With FN/FR in Conservatorship

• State and local agency holdings have fallen as FNMA and FHLMC have shrunk debt outstanding. • What should managers do with the portion of the portfolio traditionally held in agencies? • Stay in agencies? • Migrate to SSA? • Both?

Outstanding Non-DN Agency Debt ($ tn) State and Local Agency Holdings ($ bn)

1 Source: FNMA, FHLMC, FHLB, FFCB, FRBNY Fixed Income Strategy SSA: A Brief Overview • SSA: Key Supranational Statistics • (Sub) Sovereign – National or sub-national IFC IBRD IADB ADB AfDB EBRD EIB International International Bank for Inter-American Asian African European Bank for European • Supranational – International Finance Reconstruction and Development Development Development Reconstruction Investment Corporation Development Bank Bank Bank and Development Bank organization whose mandate Fosters Help Lends and Development economic Invests and Development finance invests equity extends across national Provides loans to bank for Latin development lends to bank which leands balanced in private Business public sector in American and and development to Eastern and economic boundaries enterprises in developing countries Caribbean cooperation projects in Central European developme developing economies in the Asia Africa economies nt in EU • Agency – Government countries Pacific region states sponsored corporation that 67 member 48 member 54 African countries, of countries, member typically functions for a social or which 23 are 66 members - 64 28 member 184 member 189 member consisting of countries and Ownership OECD countries, the EU states of the public need countries countries Latin America 25 non-African countries and the EIB EU and OECD member holding 64.6% • BMO’s SSA Cheat Sheet is a good countries countries of total resource for an overview of each Total Assets ($ bn) $94 $403 $126 $182 $46 $67 $659 entity’s business and key information Liquidity Liquid Assets/Total Assets 41% 18% 26% 20% 39% 44% 13% Leverage Total Liabilities/Total Liabilities + 72% 90% 74% 72% 78% 71% 87% Shareholder's Equity (excluding callable capital) Total Shareholders Equity $26 $42 $32 $50 $10 $19 $83 Paid-in capital as % of total capital 100% 6% 7% 5% 7% 21% 9% Net income before Transfers ($ mn) $1,360 $876 $615 $774 $358 $892 $3,240

2 Source: IFC Investor Presentation Fixed Income Strategy SAFETY: Agencies Have Very Strong Balance Sheets and a Strong Implicit Guarantee FHLB Credit Exposure and Collateral ($ bn) • Agency Credit Quality: • Strong balance sheets. FHLB has never had a credit loss on its advance portfolio in its history given collateral backing loans. • FNMA/FHLMC mortgage portfolios are much stronger following increased underwriting standards after the crisis. • FFCB has a strong asset portfolio, with nonaccrual loans at less 1% ot total. Some loans are also collateralized. • Implicit guarantee from the United States government, which would likely be used were it ever necessary (FNMA/FHLMC). Single Family Delinquency Rate (%) FFCB Nonaccrual Loans (% of Total Loans)

0.69%

3 Source: FNMA, FHLMC, FHLB, FFCB Fixed Income Strategy SAFETY: Supranationals Offer the Safety of Multiple Governments • Supranational Credit Quality: • Backed by paid-in and callable capital from member countries. • Callable capital sufficient to cover outstanding debt even assuming 100% default rates on their loan portfolios. • Have never had to make a claim on callable capital. • Preferred creditor status.

IADB Loans and Available Capital ($ bn); IADB Callable World Bank Loans and Available Capital Capital = $164.9 bn

4 Source: IBRD/IADB Investor Presentation Fixed Income Strategy SAFETY: Washington Supranationals Offer an Additional Degree of • The United States is the largest shareholder of each of the supranationals, representing at least 15% of each, and each is headquartered in Washington DC. • Structural changes to the supranationals require an 85% supermajority, therefore the United States is the only country that retains the power to veto structural changes at IBRD, IFC and IADB.

Member Countries with the Highest Share of Voting Power

5 Source: IBRD/IADB/IFC Investor Presentation Fixed Income Strategy SAFETY: Strong Credit Quality Makes Agencies and SSAs “Flight to Quality” Assets

• Inverse correlation between agency/supra yields and corporate credit default swap rates • Both agencies and supranationals had positive total returns in 2008 during the peak of the financial crisis, while corporates were negative and stocks were sharply negative.

5yr Corporate CDS and Agency/SSA Yields 2008 Total Return (%)

6 Source: BMO CM, Bloomberg Fixed Income Strategy LIQUIDITY: Bid/Ask is One Often Used Measure of Liquidity… • Liquidity is stronger in the agency market with a bid/ask spread consistently below 2bp. • Supranational liquidity improving as more market participants become familiar with the market. • SSA bid/ask spreads similar to agencies in normal times, but still vulnerable to drops in stressed market environments, such as the experience during Brexit in mid 2016. • Corporate bid/ask typically around 10bp

Bid/Ask Spread (bp)

7 Source: , , Bloomberg, BMO Capital Markets Fixed Income Strategy LIQUIDITY: …Another is Market Depth • According to TRACE statistics, approximately $3.75 bn of agency securities trade each day, down from ~$6bn per day in 2013, and well below corp/MBS markets. • However, when comparing trading volume to market size, 0.03% of the non-DN agency market trades each day, on par with corporates and MBS. • Unfortunately, supranationals are exempt from TRACE reporting. How can we compare liquidity?

Average Daily Trading Volume ($ bn) Monthly Trading Volume/Market Size (%)

8 Source: TradeWeb, , Bloomberg, BMO Capital Markets Fixed Income Strategy LIQUIDITY: MEC Can Also Be Helpful in the Absence of TRACE Statistics • Market Efficiency Coefficient (MEC) is a measure of liquidity that essentially focuses on how orderly price movements incorporate new information. • As expected, Treasuries are first and agencies are second. Supranationals trade with liquidity more like agencies than like corporates.

MEC Between 2013 and 2018

9 Source: TradeWeb, , Bloomberg, BMO Capital Markets Fixed Income Strategy RETURN: Impressive Credit/Liquidity with a Spread to Treasuries

• Agency/supranational spreads to Treasuries Agency Spread to Treasuries tighter than the average over the past five years. • Supranational spreads are wider than agencies at the short end, but narrower at the long end.

Supranational Spread to Agencies Supranational Spread to Treasuries

10 Source: TradeWeb, BMO Capital Markets Fixed Income Strategy Name Diversification 2017-18 Net Agency Issuance ($ bn) USD Non-DN Debt Outstanding ($ bn) • FHLB/FFCB now account for most GSE issuance, and could run up against name limits • The USD SSA market has grown to 100% of the non-DN US agency market, compared to 23% in 2008.

Agency Non-DN and SSA Debt Outstanding ($ bn)

11 Source: FNMA, FHLMC, FHLB, FFCB, Bloomberg Fixed Income Strategy Gross Agency Issuance ($ bn) Diversification of Product Type

• While gross issuance in the agency market remains far larger than SSAs, SSAs issue more benchmarks than agencies. • 82% of USD SSA gross issuance comes from benchmarks, compared to just 6% for agencies. • Agencies and SSAs both offer all product types, but diversifying allows investors to target certain product types more easily. Gross SSA Issuance ($ bn) • SSAs->bullets, large deals. • Agencies-> Structured products, floaters

12 Source: FNMA, FHLMC, FHLB, FFCB, Bloomberg Fixed Income Strategy Diversification of Buyer Base Distribution of 2018 FNMA Benchmark Deals by Location(%) Distribution of 2018 SSA Benchmark Deals by Location(%)

Distribution of Post-Crisis New Issue SSA Deals (%) Distribution of 2018 FNMA Benchmark Deals by Type (%)

13 Source: BMO CM, Informa, FNMA Fixed Income Strategy LCR helps explain why banks are so much more active in the supranational market

• Every dollar used to hold HQLA is one that cannot be used to LCR Haircuts invest in higher returning investments Level 1 0% Level 2A 15% • Therefore, the haircut taken on Level 2A and Level 2B Level 2B 50% securities in the LCR is very important • SSA debt returns more than any other Level 1 eligible asset class except GNMA MBS

Source: BMO, Basel Committee 14 Fixed Income Strategy Diversification of Funding Cycle Average Post-Crisis % of Annual SSA Issuance(%) • Supranationals fund according to an annual borrowing requirement, with heavy seasonality to issuance patterns. • Agencies are needs-based funders, heavily dependent on redemptions to dictate when funding is required. • Differing funding drivers mean supply likely to be there from one or the other most of the time.

Agency Bullet/Callable Redemptions ($ bn) Average Post Crisis Monthly Gross Non-DN Issuance ($ bn)

15 Source: BMO CM, FNMA, FHLMC, FHLB, FFCB Fixed Income Strategy Diversification of Risk Exposure

SSA Credit Risk Factors Agency Credit Risk Factors

• Credit rating dependent on capital of • Credit rating dependent on US rating. countries all around the world.

• Exposed to European risk • Insulated from European risk. • Exposed to emerging market stress. • Insulated from emerging market stress. • Exposed to isolationist risk. • Insulated from isolationist risk.

• Insulated from deficit/US downgrade risk. • Exposed to deficit/US downgrade risk. • Insulated from GSE reform risk. • Exposed to GSE reform risk. • Insulated from US housing market risk. • Exposed to US housing market risk.

16 Fixed Income Strategy SOFR-Linked FRN Issuance by Type (%) Agencies/Supras are Leaders in Growing Fixed Income Markets

• SSA borrowers were the very first issuers in the sustainable market and remain important borrowers today. • SSA institutions are experts in the sustainable bond space, with frameworks and reporting standards greatly exceeding the standards of other borrowers and continue to evolve the sustainable . • The agencies have accounted for 77% of all SOFR- Green Bond Issuance ($ bn) linked issuance to date, and expect to remain the largest SOFR-linked issuing sector in the world. • Once again, both sectors are active in both markets, but each has a specialty in differing markets.

17 Source: Bloomberg, Climate Bonds Initiative, BMO Capital Markets Fixed Income Strategy Market Overview: Narrow Swap Spreads to Blame for Tight Credit Spreads

• A significant narrowing of swap spreads over the past six weeks has driven agency/supranational

spreads to the narrow end of multiyear trading ranges

3yr Spread to Treasuries (bp) Swap Spreads (bp)

18 Source: Bloomberg, TradeWeb, BMO Capital Markets Fixed Income Strategy Market Overview: Attractive ASW Valuations May Provide More Support for Supranationals

Agency Spreads Supranational Spreads vs. TSY vs. TSY Last 1wk Chg 1m Chg 3m Chg 3m Avg 6m Avg 12m Avg 3m Z Score 6m Z Score 12m Z Score Last 1wk Chg 1m Chg 3m Chg 3m Avg 6m Avg 12m Avg 3m Z Score 6m Z Score 12m Z Score 2 5.5 1.1 0.4 -4.6 6.5 6.2 6.8 -0.5 -0.3 -0.5 2 10.2 -0.4 -0.8 -5.7 12.4 13.5 15.6 -1.0 -1.4 -1.5 3 5.0 -0.4 -2.5 -0.8 6.3 5.6 5.7 -1.1 -0.5 -0.4 3 9.7 1.9 -3.5 -2.3 12.7 12.8 14.8 -2.1 -2.3 -1.9

5 8.7 0.8 -1.0 -3.4 9.8 9.9 10.4 -0.9 -0.9 -1.0 5 12.8 -0.7 -2.3 -1.0 15.1 14.4 15.8 -1.6 -1.2 -1.3

7 20.0 1.0 -4.0 1.7 21.9 18.6 18.3 -0.9 0.4 0.4 7 13.9 0.4 -0.9 -2.3 15.8 15.4 16.0 -0.9 -0.9 -1.3

10 32.6 -2.0 -7.7 -1.8 38.6 33.7 30.6 -1.7 -0.2 0.3 10 15.6 -0.6 -2.2 -2.4 17.2 16.8 16.8 -1.3 -1.0 -1.1

vs. Swaps vs. Swaps Last 1wk Chg 1m Chg 3m Chg 3m Avg 6m Avg 12m Avg 3m Z Score 6m Z Score 12m Z Score Last 1wk Chg 1m Chg 3m Chg 3m Avg 6m Avg 12m Avg 3m Z Score 6m Z Score 12m Z Score 2 -8.1 0.5 1.8 0.1 -8.2 -10.9 -15.0 0.1 0.9 1.3 2 -3.3 -1.0 0.5 -0.1 -2.4 -3.8 -6.3 -0.5 0.3 0.8

3 -5.7 -1.0 -1.4 3.6 -5.3 -8.9 -12.7 -0.2 0.8 1.3 3 -0.9 -1.0 -2.4 2.3 1.1 -1.7 -3.3 -1.0 0.3 0.8

5 0.2 0.0 0.0 2.0 1.0 -1.8 -3.5 -0.5 0.6 1.1 5 4.3 -1.5 -1.6 4.5 6.0 2.5 2.3 -0.9 0.5 0.6

7 16.2 0.5 -2.9 4.9 17.6 12.5 11.2 -0.5 0.7 1.1 7 10.8 0.4 0.4 3.2 11.1 8.8 9.5 -0.2 0.8 0.5

10 30.5 -1.7 -6.7 0.9 35.4 28.7 25.4 -1.3 0.2 0.8 10 13.4 -0.2 -0.8 0.8 13.8 11.7 11.8 -0.3 0.7 0.7

19 Source: TradeWeb, BMO Capital Markets 2yr Intersector Spreads (bp)

2yr vs. Swaps US Agency Washington Supra Euro Supra Euro Agency CAD Provie Covered US Agency -- 6.0 7.3 11.3 22.0 35.2 Fixed Income Strategy Washington Supra -6.0 -- 1.4 5.3 16.0 29.3 Euro Supra -7.3 -1.4 -- 3.9 14.6 27.9 Market Specific Discussion: Agencies Euro Agency -11.3 -5.3 -3.9 -- 10.7 24.0 CAD Provie -22.0 -16.0 -14.6 -10.7 -- 13.3 Covered -35.2 -29.3 -27.9 -24.0 -13.3 -- 2yr vs. Swaps US Agency Washington Supra Euro Supra Euro Agency CAD Provie Covered US Agency -- -1.2 -1.2 -1.5 -1.6 -0.6 • Relative value favors agencies as the Washington Supra 1.2 -- 0.0 -1.4 -0.5 0.1 Euro Supra 1.2 0.0 -- -1.5 -0.6 0.1 spread give up for other traditionally Euro Agency 1.5 1.4 1.5 -- 0.7 1.0 CAD Provie 1.6 0.5 0.6 -0.7 -- 0.5 higher spread sectors is low compared Covered 0.6 -0.1 -0.1 -1.0 -0.5 -- to trading ranges over the past year 3yr Intersector Spreads (bp) 3yr vs. Swaps US Agency Washington Supra Euro Supra Euro Agency CAD Provie Covered US Agency -- 5.0 4.3 12.7 25.4 35.8 • However, agency spreads to Treasuries Washington Supra -5.0 -- -0.7 7.7 20.4 30.8 Euro Supra -4.3 0.7 -- 8.4 21.1 31.5 are rich on an absolute basis, Euro Agency -12.7 -7.7 -8.4 -- 12.7 23.1 CAD Provie -25.4 -20.4 -21.1 -12.7 -- 10.4 particularly in the short end Covered -35.8 -30.8 -31.5 -23.1 -10.4 -- 3yr vs. Swaps US Agency Washington Supra Euro Supra Euro Agency CAD Provie Covered US Agency -- -1.7 -2.3 -2.7 -1.7 -1.9 Washington Supra 1.7 -- -2.2 -1.6 -0.8 -0.7 Euro Supra 2.3 2.2 -- -0.4 0.5 0.3 vs. TSY Euro Agency 2.7 1.6 0.4 -- 0.6 0.5 Last 1wk Chg 1m Chg 3m Chg 3m Avg 6m Avg 12m Avg 3m Z Score 6m Z Score 12m Z Score CAD Provie 1.7 0.8 -0.5 -0.6 -- 0.0 Covered 1.9 0.7 -0.3 -0.5 0.0 --

2 4.4 -0.9 -0.9 -5.0 7.3 6.0 6.9 -1.4 -0.7 -1.0 5yr Intersector Spreads (bp)

5yr vs. Swaps US Agency Washington Supra Euro Supra Euro Agency CAD Provie Covered 3 7.0 -0.6 -1.1 2.0 6.2 5.4 5.7 0.6 1.1 0.7 US Agency -- 3.9 4.4 15.1 34.4 50.2 Washington Supra -3.9 -- 0.5 11.2 30.5 46.3 Euro Supra -4.4 -0.5 -- 10.7 30.0 45.8 5 10.1 -0.1 0.2 -1.1 10.4 9.9 10.6 -0.2 0.2 -0.3 Euro Agency -15.1 -11.2 -10.7 -- 19.3 35.1 CAD Provie -34.4 -30.5 -30.0 -19.3 -- 15.8 Covered -50.2 -46.3 -45.8 -35.1 -15.8 -- 7 21.8 -0.2 -2.1 5.8 21.4 18.7 18.0 0.1 0.8 1.0 5yr vs. Swaps US Agency Washington Supra Euro Supra Euro Agency CAD Provie Covered US Agency -- -0.8 -2.2 -0.8 -0.1 1.5 Washington Supra 0.8 -- -2.0 -0.5 0.7 1.6 10 36.2 -4.2 -6.3 5.8 38.0 33.4 29.9 -0.4 0.5 1.0 Euro Supra 2.2 2.0 -- 1.3 1.8 2.0 Euro Agency 0.8 0.5 -1.3 -- 0.7 1.6 CAD Provie 0.1 -0.7 -1.8 -0.7 -- 1.8 Covered -1.5 -1.6 -2.0 -1.6 -1.8 --

20 Source: TradeWeb, BMO Capital Markets Fixed Income Strategy Retained MBS Portfolios and Cap ($ bn) Market Specific Discussion: Agencies

• Gross agency issuance now dominated by floaters

(Money market reform/SOFR)

• Bullet and callable net issuance has been negative for the majority of the decade

Gross Agency Issuance ($ bn) Net Agency Issuance ($ bn)

21 Source: Bloomberg, FNMA, FHLMC, BMO Capital Markets Fixed Income Strategy Market Specific Discussion: Agencies

• The Trump administration is expected to announce a plan for GSE reform in the near future

• The plan is expected to include Congress; Trump does not want to unilaterally reform the GSEs

• Expect the announcement to quickly follow the confirmation of Mark Calabria as the next Director of the

FHFA

10yr Agency Spread to TSY (bp) Recent Jan 6 – Mel Watt’s Term as FHFA Director Ends GSE Reform Events Jan 18 – Acting Director Otting tells GSE employees a plan to end conservatorship expected “within weeks”

Jan 29 – White House spokesperson walks back Otting’s comments and says that the Trump administration expects to release a plan for Congressional GSE reform “shortly”

Feb 27 – Senate Banking Committee approves Mark Calabria as next FHFA Director

22 Source: Bloomberg, TradeWeb, BMO Capital Markets Fixed Income Strategy Market Specific Discussion: Agencies

• Callables perform well in environments where interest rates are range bound, and a compelling

argument could be made that we’re in such an environment

• However, volatility is near cycle lows once again. If/when volatility does increase, perhaps surrounding Brexit, we favor callables

Swaption Volatility (bp) Chart on Callable Issuance

23 Source: Bloomberg, YieldBook, BMO Capital Markets Fixed Income Strategy Net USD SSA Issuance ($ bn) Market Specific Discussion: Supranationals

• USD SSA market issuance has been extremely light over the past year • This is partly because of more attractive funding costs in other currencies, but the SSAs simply borrowing less is the primary driver

• Technicals likely to keep spreads low

Gross and Net SSA Issuance in all Currencies Through Feb ($ bn) Gross and Net USD SSA Issuance Through Feb ($ bn)

24 Source: Bloomberg, BMO Capital Markets Fixed Income Strategy Market Specific Discussion: Supranationals

• Relative value picture favors supranationals that most government portfolios have approved

• Getting additional SSAs on approved lists can pay off when spreads for tier 2 SSAs move wider

3yr Spread to TSY (bp)

3yr IG Spread to Supra (bp)

25 Source: Bloomberg, TradeWeb, BMO Capital Markets Fixed Income Strategy In Conclusion

Supranationals Despite tight spreads, supranationals likely to receive some Watch for GSE reform headlines that have the Agencies support from asset swappers and short end spreads are relatively potential to significantly impact GSE spreads attractive

Long end agency bullets are a compelling play on Little compelling value further out the curve reform headlines

Despite favorable relative value, short end bullet spreads offer little value at current levels and likely need some swap spread widening Structured supranational debt can offer a modest pickup over agency structured notes, and are also attractive in the current Callables/structured notes make sense in the market environment current market environment, and we like adding to these positions during transitory spikes in vol Sustainable bonds present an opportunity for additional Agency market a great way to add SOFR outperformance if overwhelming demand results in a premium exposure

Work to add other SSAs to approved lists for further diversification and enhanced yield when spreads on tier 2 borrowers move wider

26 Source: Bloomberg, Climate Bonds Initiative, BMO Capital Markets Disclaimer

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