Big bond investors seeing QE3 on the horizon

Bill Gross, Jeffrey Gundlach and Dan Fuss, whose firms collectively oversee about $1.5 trillion, expect the Federal Reserve to conduct a third round of bond purchases as signs of strength in the U.S. economy fade and Europe's sovereign-debt crisis returns.

The managers at Pacific Investment Management Co. and DoubleLine Capital LP favor mortgage debt, while Loomis Sayles & Co. purchases corporate bonds. Speculation that the Fed will buy home-loan debt with quantitative easing has led 2012 returns on government-backed mortgage bonds to exceed Treasuries by 0.96 percentage points, Barclays PLC index data show.

Fed Chairman Ben S. Bernanke, Vice Chairman Janet Yellen and New York Fed President William C. Dudley signaled further easing may be needed if growth lags projections, with headwinds ranging from the end of tax breaks to $1 trillion of mandatory federal budget cuts to $100-a-barrel oil eating into consumer spending. The Standard & Poor's 500 has fallen as much as 4.8% from an almost four-year high on April 2.

“Should the stock market keep going down, it will be a portent of weaker economic data,” said Mr. Gundlach, whose $22.8 billion DoubleLine Total Return Bond Fund outperformed 99% of peers last year. “It will happen and when it does you will start to hear about more support programs.”

While gross domestic product grew at a 3% pace in the last three months of 2011, it will slow to 2.3% this year, according to the median estimate of 90 economists surveyed by Bloomberg.

Mr. Gross, the manager of the world's biggest bond fund, boosted holdings of mortgages last month to the most in almost three years. Mr. Fuss, a member of the Fixed Income Analysts Society Hall of Fame, said this week that the Fed may stick with quantitative easing until after the presidential election or the unemployment rate falls to about 6% from its current 8.2%.

Elsewhere in credit markets, Deutsche Bank AG, Barclays and Credit Suisse Group AG are among banks preparing bids for a $7.49 billion mass of real estate debt that the Federal Reserve Bank of New York assumed in 2008. The U.S. commercial paper market contracted to the lowest level in more than a month. Emdeon Inc., which Blackstone Group LP acquired last year, is seeking to set the rate on a $1.22 billion term loan repricing.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 0.39 basis points to 28.75 basis points. The gauge, which reached a more than two-month high of 31.69 on April 10, narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

The cost of insuring against a default on Spanish sovereign debt approached a record-high as the nation struggled to avoid becoming the fourth euro-region member to require a bailout.

Credit-default swaps on Spain rose seven basis points to 489, near the all-time high of 493 set Nov. 23, according to CMA prices. The contracts are up from 431 at the start of the month and 380 at the end of 2011, signaling deterioration in investor perceptions of credit quality since then.

Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Bonds of Fairfield, Conn.-based General Electric Co. were the most actively traded U.S. corporate securities by dealers Thursday, with 120 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Deutsche Bank, Barclays and Credit Suisse are preparing bids after the New York Fed said last week that it's considering selling assets in its Maiden Lane III LLC portfolio, according to people familiar with the transaction. Goldman Sachs Group Inc. has also approached investors about preparing a bid.

The holdings, taken on in the bailout of American International Group Inc., include two collateralized debt obligations tied to commercial property loans issued by Deutsche Bank in 2007 and 2008.

The seasonally adjusted amount of U.S. commercial paper dropped by $3.1 billion to $928.5 billion in the week ended April 11, the second consecutive decrease, the Fed said Thursday on its website. That's the least since March 7.

The S&P/LSTA U.S. Leveraged Loan 100 index rose for the first time this month, increasing 0.01 cent to 93.40 cents on the dollar. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has returned 4.23% this year.

Leveraged loans and high-yield bonds are rated below Baa3 by Moody's Investors Service and lower than BBB- by S&P.

Emdeon's debt due in November 2018 will pay interest at 3.75 percentage points more than the London interbank offered rate, according to a person with knowledge of the transaction, who declined to be identified because terms are private. Libor, a rate banks say they can borrow in dollars from each other, will have a 1.25% floor. The debt is being sold to investors at par, the person said.

The provider of billing systems and software for health-care companies is also seeking a $60 million incremental term loan due in November 2018 that will pay the same interest. Proceeds from the financing will be used for general corporate purposes including potential acquisitions, the Nashville, Tenn.-based company said in a statement.

In emerging markets, relative yields narrowed for a second day, declining eight basis points to 353 basis points, or 3.53 percentage points, according to J.P. Morgan Chase & Co.'s EMBI Global index. The measure has averaged 375 basis points this year.

The mortgage-bond market is showing investors anticipate more stimulus from the Fed. Yields on Fannie Mae's current-coupon 30-year mortgage bonds ended Thursday at 88 basis points more than 10-year Treasuries, down from about 100 basis points on Dec. 31, according to data compiled by Bloomberg. The type of securities, which most affect home-loan rates because they trade closest to face value, may be targeted by the Fed.

Primary dealers agree with investors, with 15 of the 21 firms that trade with the Fed saying odds are that the central bank will need a third round of bond purchases to bolster the economy, according to a Bloomberg News survey published April 2.

In its first two rounds of stimulus in response to the credit crisis, the Fed bought $2.3 trillion of bonds from December 2008 to June to avert deflation and spur growth. It's now replacing $400 billion of shorter-term maturity Treasuries in its holdings with longer-term debt in a policy traders call Operation Twist.

Central bankers next meet in two weeks to debate policy for an economy that Mr. Dudley and Ms. Yellen said may be softening. Projections for GDP growth this year are slower than the 3.1% posted in 2005 and 2.7% in 2006 before the recession and financial crisis.

Fed officials called for additional stimulus only “if the economy lost momentum” or if inflation stays below their 2% inflation target, according to minutes of their March 13 meeting released April 3.

“Considerable uncertainty surrounds the outlook,” Ms. Yellen said April 11 in a speech in New York. “I consider a highly accommodative policy stance to be appropriate in present circumstances.”

Mr. Dudley, in a speech Thursday to business leaders in Syracuse, N.Y., said “it is still too soon to conclude that we are out of the woods.”

Europe's fiscal imbalances are again threatening to infect the global financial system, with yields on Spanish 10-year bonds topping 6% this week, approaching the 7% level that prompted Greece, Ireland and Portugal to seek bailouts.

“The problems in Europe are getting bigger,” Mohamed El- Erian, co-chief investment officer of PIMCO, said Wednesday. “Europe has a debt issue and Europe has a growth issue, and until Europe deals with both, we are going to have these reoccurring periods of nervousness in the market.”

Tax reductions enacted by former President George W. Bush are scheduled to expire at the end of 2012 and $1 trillion in automatic cuts in government spending will begin in January. Crude oil prices have soared to $103.67 a barrel, from last year's low of $75.67 on Oct. 4.

Some Fed policy makers have struck a more hawkish tone. Atlanta Fed President Dennis Lockhart, a voting member of the Federal Open Market Committee this year, said in an April 3 interview that he would need to see some “pretty severe circumstances” before he would endorse more quantitative easing.

“With an improving economy, the argument for extraordinary measures frankly becomes less tenable,” said Kenneth Taubes, chief investment officer in Boston for Pioneer Investment Management Inc., which oversees almost $30 billion in bonds.

PIMCO's Mr. Gross raised the $252.4 billion Total Return Fund's holdings of mortgage bonds to 53% of assets in March, the highest since June 2009, from 52% in February, according to a report on the company's website on April 11. He reduced the proportion of U.S. government and Treasury debt to 32% last month from 37% in February.

The Fed will probably shift focus to buying mortgage securities to keep borrowing rates low when its Operation Twist program ends in June, Mr. Gross said in a March 28 interview.

“Without QE, the financial markets and then the economy will falter,” Mr. Gross said in a Twitter post April 4. In a post Thursday, he wrote that speeches this week by Ms. Yellen and Mr. Dudley damped the probabilities of QE3.

Mr. Gundlach said softer economic numbers would push the Fed to act.

“I just don't think that we have a healthy fundamental foundation for the economy and therefore surprises are likely to be on the negative side,” Mr. Gundlach said in a telephone interview from Los Angeles. His fund, which invests in mortgages, had 34% of its money in non-agency residential mortgage-backed securities as of March 31, according to the DoubleLine website.

Mr. Fuss' $21 billion Loomis Sayles Bond Fund favors corporate bonds, according to Matthew Eagan, one of the portfolio managers. “We like them in a scenario in which the U.S. economy muddles through,” Mr. Eagan said in a telephone interview. Europe's debt crisis is another issue that may tilt the Fed toward more easing.

“Bernanke, Yellen and Dudley are all biased towards additional easing,” Robert Michele, global chief investment officer for fixed income and currency at J.P. Morgan Asset Management, said in a telephone interview from New York.

Mr. Michele, who oversees $125 billion in fixed-income assets, predicted the central bank would come back with more easing “as we get into summer and fall” in the U.S.