Callable Agency Securities: The Challenge to Enhance Liquidity in the Secondary Market

Despite certain fundamental obstacles to the growth of callable agency debt, its issuance has become increasingly important to the nation’s government-sponsored enterprises (GSEs).
    In recent years, a surge in this issuance has contributed significantly to the overall growth of GSE debt issuance. But while investor demand for callable debt has grown, the depth and liquidity of secondary market trading has not kept pace. Attempting to address this situation, the Association recently formed a Callable Agency Securities Task Force to examine existing trading conventions and explore whether steps should be taken to foster greater liquidity and price transparency in the market.
    In this roundtable discussion, Eric L. Foster, Association Vice President and Assistant General Counsel, and Staff Advisor to the Task Force, talked with the Task Force leadership as well as representatives from the issuer and investor communities about the role of the Task Force and their respective plans for improving the marketplace.
    Roundtable participants were: Michael Graf, Managing Director, Merrill Lynch Government Securities, Inc.; Jeff Carleton, Managing Director, Salomon Smith Barney Inc.; Sean Kelleher, Senior Vice President, Alliance Capital Management L.P.; Joseph M. Cousins, Director, Term Funding, Federal Home Loan Banks Office of Finance; John Radwanski, Senior Portfolio Director, Freddie Mac; and James Zucco, Director, Long-Term Funding, Fannie Mae.

What is driving the growth of callable agency securities issuance? Will it continue?

Carleton: The housing agencies need to buy optionality to hedge their mortgage portfolios; hence, they issue callable debt. This means that each agency’s asset portfolio contains an imbedded option in nearly every mortgage the agency owns. To hedge this option, the agency must issue or purchase an offsetting option in the derivatives market. The Federal Home Loan Bank issues callable debt as well, but typically sells the option in the derivatives market.

    Gross callable issuance has increased during the past two years, due largely to the unprecedented amount of mortgage and callable bond redemptions precipitated by the fall in yields. However, overall net callable debt issuance should grow roughly at the same rate as the agencies’ portfolios.

Kelleher: With the tremendous balance-sheet growth of the GSEs over the past few years, the GSEs have realized that the only way to tap into larger investors is by standardizing the market and improving transparency. Thus, we are seeing multibillion-dollar callable deals priced at regular intervals, much like the successful benchmark and reference note markets.

Is much of the callable agency debt issued in the primary market intended to satisfy specific investor demand for particular coupons, calls and maturities?

Zucco: Fannie Mae issues a diverse number of callable bonds with a variety of final maturities and call lockout periods, resulting in securities with a wide range of varying duration and convexity profiles. We issue daily through our callable Medium-Term Note program, allowing us to respond to specific dealer and investor needs to match their investment criteria and interest rate outlooks. Fannie Mae has also committed to a Callable Benchmark Note (CBN) program that provides investors and other market participants with large callable structures, minimum $2 billion, on a monthly basis.

Why has Freddie Mac recently announced certain refinements to its syndicated callable note offerings?

Radwanski: The changes announced to our callable note offerings were market clarifications on how Freddie Mac will issue large global syndicated callable notes. These clarifications include using a three-dealer lead manager group, locking out the global structure from medium-term-note (MTN) issuance three days prior to launch until three days after pricing and targeting a $2 billion issue. These changes were in response to investor interest in large liquid callable notes and our desire for successful transactions by issuing into investor demand.

The FHLB Office of Finance has been one of the largest issuers of callable debt in recent years. Why?

Cousins: A large portion of our current issuance activity replaces bonds that have matured or been called. In 2001, the FHLBanks issued $383 billion in bonds, while total debt outstanding grew by only $23 billion. The decision to redeem a bond is based on whether or not the option on that security is in-the-money. If it makes economic sense to redeem an issue, the FHLBanks will generally call the bonds. The pace of redemptions will therefore be driven by the future direction of interest rates.

Callable agency securities are increasingly popular with foreign investors and are traded overnight in Tokyo and London. How are these overseas markets progressing as viable secondary markets? What steps could be taken to increase primary and secondary market activity?

Carleton: Until the emergence of a standardized callable calendar with specific callable bond structures, which would allow dealers to consistently short callable securities, as well as a common pricing methodology, there will likely be a ceiling to the liquidity of the secondary callable market in both overnight and New York hours.

    Nevertheless, Asian participation in callable markets remains quite robust, particularly in maturities shorter than five years, and European investors have been more active in callables since the advent of the large callable issues. However, the overnight-investor base is less trading-oriented.

Graf: I agree. The overseas investor has been a buy-and-hold customer. Typically, they have purchased existing inventory from dealers or have placed orders for targeted new issues.

Zucco: We believe that international investors have found that the one-time call features are easier to analyze and hedge than the continuous call structures. We also believe that the overseas markets for all of our callable debt securities will continue to improve as our dealers commit more dedicated and seasoned sales and trading resources to Tokyo, Hong Kong and London.

How does the secondary market for callables operate? What are the practical challenges and risks dealers face when making a two-sided market in these securities?

Graf: The secondary market for callables does need some work. It represents a tale of two markets: The larger liquid issues trade on a frequent basis and are quoted on a tight bid/ask market. There is also an active repo market in these securities that facilitates two-way trading, and this has helped market liquidity. A number of dealers use these securities to hedge their position risk and thus may use secondary bidding to actually cover a short position. A number of recent market trends have facilitated this activity. Of particular note is Bloomberg’s OASF function, which has enabled the Street to quote and trade callable securities in a format that closely correlates to the underlying valuation.

    In contrast, the less liquid off-the-run MTN issues trade “off screen” on an infrequent basis. Most of these issues are ultimately sold to buy-and-hold customers that do not want to pay the higher price associated with liquid on-the-run issues. The bid/ask spreads on these issues are wider and reflect their lack of liquidity.

Carleton: There are a variety of reasons that dealers have difficulty making a two-sided market. Without the existence of a structured and specifically delineated calendar, a liquid repo market for callables cannot exist, and therefore dealers can’t consistently short callable bonds. The wider bid/offer spread for callables reflects this fact as well as the additional risks associated with hedging the embedded call option. Additionally, valuation of callable bonds differs across dealers due to lack of market convention and uniformity. Finally, while many dealers are set up for new-issue callable securities, few dealers are willing to trade and hold secondary callable inventory. This also leads to wider bid/offer spreads.

How then are these securities quoted and traded in the secondary market and by the inter-dealer brokers (IDBs)?

Carleton: Many dealers still value callables with option-adjusted spreads (OAS), assuming 14 percent volatility. However, bellwether callable bonds rely on different trading parameters. For example, Fannie Mae Callable Benchmarks trade using Bloomberg’s OASF screen, while Freddie Mac’s syndicated callables trade using a spread to U.S. Treasuries. MTNs often trade across a variety of market conventions and are the least standardized of all callable products.

Do you believe that the different methodologies used to value these securities and the proliferation of pricing curves are a sign of an expanding investor base?

Graf: Yes. The investor community is varied and they will evaluate callables differently depending on their overall strategy. This is especially true when we see cross-sector trades where investors are moving assets among classes. These investors attempt to evaluate both assets against a common curve, LIBOR. Another common practice involves intra-sector trades, whereby the investor is comparing callables versus bullets. In this approach, discounting the cash flows against a “fair market” bullet curve gives the most accurate comparison. Of utmost importance in all these approaches are the input data sources that make up the varied curves. The market needs access to a common data set to facilitate both evaluation and trading.

Radwanski: The investor base for callable agency securities is expanding. That, coupled with the fact that callable securities are complex instruments with no standard market convention for trading and pricing them, has led to multiple methodologies for valuation. Market participants will always have different valuation techniques, but the size of the callable agency securities market has grown to the point where it is important that trading conventions are developed so that, regardless of how anyone evaluates the security, there is agreement on how the transactions trade in the market.

Carleton: I agree. There’s no need for one standard relative-value metric; however, a common and standardized method for trading and quoting callables would improve liquidity in the callable market.

Is the growing use of OAS a significant step toward better defining a callable security’s effective duration and convexity and the implied value of the imbedded call option?

Radwanski: OAS has positive and negative aspects as a valuation tool. It is up to individual market participants to determine what type of metrics they are interested in looking at for these securities. The key challenge is to develop standard inputs to an OAS model, including volatility assumptions and an interest rate curve, that will allow everyone to agree on a trading value for these securities. From there, individuals can determine their own valuation metrics.

Zucco: The recent trend toward a dynamic volatility assumption linked to the swaption market does seem to indicate a continued trend in sophistication for “stripping out” the value of the embedded option. We are encouraged by the increased use of OAS trading and believe it will lead to improved liquidity.

Graf: Yes, evaluating callable agencies on an OAS basis is a far more accurate way of evaluating and trading these notes.

What were the specific conditions that led to the creation of the Association’s Task Force?

Radwanski: The catalyst for the Task Force has been the new investors in these large issues who are used to the standardized trading of Treasuries, agencies and mortgages. The creation of the Task Force will hopefully lead to market standards for trading that will improve liquidity, which in turn will encourage more investors to use callable agency securities in their portfolios.

Graf: The issuance of larger callable deals in the market has led directly to the creation of the Task Force. For these deals to succeed, there needs to be a standard quotation convention for trading. This standardization should include model selection, common data inputs and a set of accepted trading practices. Currently, trading occurs on a haphazard basis, with a multitude of market quoting methodologies. The definition of a common language to be used for both primary and secondary market making will facilitate ease of execution and thus lead to greater transparency and liquidity within the sector.

Kelleher: Standardization of quoting and calculation conventions does indeed remain a critical issue.

What groups are represented and how is the Task Force organizing its work? Also, it appears there is some consensus that using a simple Black’s Model might be the right approach for quoting certain large European-style callables on an OAS basis. What do you think of this idea?

Graf: The Task Force was created to evaluate and make recommendations that would enhance the trading of callable securities. It is composed of a broad group of professionals who include buyside, issuer, dealer, broker and vendor participants. This collective group has been divided into subcommittees to analyze the various components. These subgroups include: a modeling group, a trading practices group, a data input group and eventually will include an investor education group.

    Each of the individual subgroups have been meeting over the summer and have made significant progress toward understanding the problems and evaluating proposed solutions. We are targeting early Fall to draw these groups back together and integrate their work into a trading framework. The effort should result in a common “language” that will support the trading of this product.

It is important to note that we are trying to define a common language to facilitate the trading of these securities. Hopefully, once this framework is in place, market forces will implement the proposed guidelines among a variety of trading platforms. The solution cannot be vendor-specific and must be available to the investor community as a whole.

Radwanski: The broad participation in the Task Force should make it successful, because views from all types of market participants will be represented. By having subcommittees for data input, modeling, and trading practices, we will be sure to cover all of the issues raised by this complex task.

    The tentative consensus on the Black’s Model makes sense for European-style callables as a simple, clear model to facilitate secondary market trading and is a good example of some of the future recommendations that the market can expect from this Task Force.

Zucco: We are encouraged by the formation of the task force and supportive of any effort to further the liquidity of the market through increased standardization of callable agency trading, including model and trading protocol improvements.

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