Nov. 25 (Bloomberg) -- Treasuries rose for the first time in three days as the Federal Reserve’s plan to purchase as much as $600 billion in mortgages prompted investors to buy government debt to hedge against losses in their portfolios.

Investors holding mortgage securities often use swaps and Treasuries to guard against swings in interest rates, which can trigger changes in levels of expected mortgage refinancing and duration, a measure of the average maturity of their holdings. A swap is an agreement to exchange fixed- for variable-rate payments. The hedging came as reports showed the economy contracted in the third quarter and housing prices plunged.

“The plan to buy $600 billion will take a lot of duration out of the market, which will be equivalent to several hundred billion dollars of 10-year notes,” said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York.

Yields on the 10-year note tumbled 24 basis points, or 0.24 percentage point, to 3.09 percent at 4:25 p.m. The 3.75 percent security due in November 2018 climbed 2 1/32, or $20.31 per $1,000 face amount, to 105 19/32. Yields on 30-year bonds fell 17 basis points to 3.62 percent.

Treasuries extended gains after a record $26 billion auction of five-year notes drew a yield of 2.110 percent, lower than the 2.164 percent in trading just before the sale.

The difference between the yields of 10-year Treasuries and the 30-year current coupon Fannie Mae security narrowed 30 basis points to 1.79 percentage points after reaching 2.33 percentage points on Nov. 20, the widest since March 6.

‘Have to Hedge’

“Because mortgage rates are down, mortgage pre-payments are up, so investors have to hedge,” said Tony Crescenzi, chief bond strategist at Miller Tabak & Co. in New York. “The prepayment levels have just changed dramatically.”

Many investors expected a rapid drop in mortgage rates after the Fed announced its plan to increase home-loan refinancings, which would mean early repayment of their mortgage bonds. They purchased Treasuries to stabilize the average life of their portfolios against benchmarks used by most fund managers. Treasuries mirror many of the characteristics of home loans without the risk of prepayment.

“By buying Treasuries, you are buying something that is not prepayment-affected,” said Stephen Van Order, a debt strategist in Bethesda, Maryland, at Calvert Asset Management, which oversees $10 billion in bonds. “So you buy some Treasuries” and rebuild the average life of your portfolio.

Note Auction

The five-year note’s yield plummeted 18 basis points to 2.02 percent after the sale of the new securities.

The auction drew stronger-than-average demand, judging by the bid-to-cover ratio, which compares the number of bids with the amount of securities offered. The ratio was 2.44, compared with an average of 2.12 at the past 10 sales.

The difference between yields on two- and 10-year Treasuries narrowed 19 basis points to 1.93 percentage points.

The Standard & Poor’s 500 Index rose 0.7 percent after falling as much as 2 percent. It has lost more than 40 percent this year.

Gross domestic product contracted in the third quarter at a 0.5 percent annual pace, the most since the 2001 recession, a Commerce Department report today showed. House prices in 20 U.S. cities declined in the year ended in September at the fastest pace on record, the S&P/Case-Shiller home-price index showed.

Concern the worldwide recession is deepening drove two-, five-, 10- and 30-year Treasury yields to their lowest levels on Nov. 20 since regular sales of the securities began. Two-year note yields dropped to 0.95 percent. Five-year notes touched 1.87 percent, 10-year notes fell to 2.99 percent and 30-year bonds reached 3.44 percent.

Nothing Else Worked

The Fed said it will set up a $200 billion program to support consumer and small-business loans, as well as buying up to $600 billion in debt issued or backed by government-chartered housing-finance companies.

“Something like this was going to happen because none of the other things were working,” said David Ader, head of U.S. government bond strategy at RBS Greenwich Capital in Greenwich, Connecticut, one of 17 primary dealers that trade with the Fed. “The market was clamoring for months and months and months and thinking the Fed’s going to have to buy this stuff in order to send out a message, and here you go.”

Since December the Fed has increased its capacity to pump funds into the economy to $2.19 trillion from $886 billion. It began with the Term Auction Facility that auctions cash loans to banks to help stabilize the financial sector and improve liquidity in various markets including short-term company loans, known as commercial paper.

‘Makes More Sense’

The central bank’s commitment to buy mortgage securities cooled speculation it may soon purchase Treasury debt to reduce yields on long-term government debt and bring borrowing costs down for companies and homebuyers.

“This makes more sense than buying Treasuries directly,” said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., another primary dealer. “That’s not where they feel they need to get rates down. It’s really on the direct credit side rather than indirectly trying to get mortgage rates down by buying Treasuries.”

The difference in yields between Treasury notes and interest-rate swaps for 10 years narrowed 7 basis points to 15 basis points, the lowest since at least 1988, when Bloomberg began tracking the instruments. The rate for 30-year interest- rate swaps fell 9 basis points to 43 basis points below the 30- year Treasury bond, the most below the debt since Nov. 20. Wider swap spreads are associated with concern over higher borrowing costs for companies.

The Securities Industry and Financial Markets Association recommended trading of Treasuries close at 2 p.m. New York time tomorrow and stay shut on Nov. 27 for the U.S. Thanksgiving holiday. It also recommended trading close at 2 p.m. New York time on Nov. 28.

To contact the reporters on this story: Daniel Kruger in London at dkruger1@bloomberg.net; Liz Capo McCormick in New York at emccormick7@bloomberg.net.

Last Updated: November 25, 2008 16:31 EST