Fannie Mae Mortgage-Bond Spreads Fall to Record: Credit Markets

March 9 (Bloomberg) -- Yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates fell to the lowest relative to Treasuries on record, even as the scheduled end of Federal Reserve purchases approaches.

The difference between yields on Washington-based Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds and 10- year Treasuries narrowed about 0.01 percentage point to 0.61 percentage point as of 4:15 p.m. in New York, the smallest gap since at least 1984, according to data compiled by Bloomberg.

Spreads on agency mortgage bonds have held near lows while the unprecedented Fed program, in which the central bank is buying $1.25 trillion of the debt, nears its March 31 conclusion. Some investors consider the debt more attractive at tighter nominal spreads because of declines in expectations for interest-rate volatility, which affects how certain they can be about how long it will remain outstanding, according to JPMorgan Chase & Co.

“While we aren’t at a point where mortgages look cheap, they’re nowhere as rich as they were,” JPMorgan analysts led by Matt Jozoff in New York wrote in a March 5 report.

Spreads for the Fannie Mae securities on a so-called option-adjusted basis, which takes into account prepayment uncertainty, against interest-rate swaps have widened to negative 0.04 percentage point from as low as negative 0.22 percentage point on Dec. 21, according to Bloomberg data. The measure also reflects how the near-record difference between two- and 10-year Treasury yields of 2.82 percent point is affecting values for mortgage bonds whose principal is repaid at various times and have a duration of about six years.

MGM Mirage

Elsewhere in credit markets, Novartis AG, Switzerland’s second-biggest drug maker, sold $5 billion of 3-, 5- and 10-year senior notes, according to data compiled by Bloomberg. MGM Mirage, the biggest casino owner on the Las Vegas Strip, sold $845 million of bonds to repay some of its loans under an arrangement it struck to extend the borrowings.

Goldman Sachs Group Inc. led the busiest day for European corporate bond issuance in eight weeks, Bloomberg data show. New York-based Goldman Sachs priced 1.25 billion euros of seven- year debt in its first benchmark deal in the currency in five months.

The extra yield investors demand to own corporate bonds rather than government debt fell 1 basis point yesterday to 162 basis points, the lowest since Jan. 21, according to Bank of America Merrill Lynch’s Global Broad Market Corporate index. Average yields were 4.05 percent, the index shows.

Markit CDX Index

The cost of protecting against U.S. corporate defaults rose from a seven-week low. The Markit CDX North America Investment- Grade Index, linked to credit-default swaps on 125 companies, increased 1 basis point to 83.5 basis points as of 4:11 p.m. in New York, according to broker Phoenix Partners Group.

The Markit iTraxx Japan index increased 1 basis point to 123 in Tokyo today, Morgan Stanley prices show. The Markit iTraxx Europe index of swaps on 125 companies with investment- grade ratings was little changed at 74 basis points, JPMorgan prices show.

Credit-swaps pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent. A basis point equals $1,000 a year on a contract protecting against default on $10 million of debt for five years.

‘Swaption’ Prices

A Barclays Capital index of expectations for interest-rate volatility based on prices for so-called swaptions fell last week to the lowest in 10 months, and has declined 11.8 percent this year. Swaptions give buyers the option to enter interest- rate swap contracts at later dates.

The gap between 10-year swap rates, another benchmark for mortgage bonds that represents the fixed rates paid in return for floating rates, and 10-year Treasuries also has declined this year, narrowing about 0.09 percentage point to 0.04 percentage point, Bloomberg data show.

Helping to reduce so-called implied volatility, investors have been selling certain contracts “to enhance returns, as opposed to owning mortgages,” Priya Misra, an analyst at Bank of America in New York, wrote in a March 5 report.

The Fed completed $1.22 trillion of net purchases of agency mortgage securities through March 3, reducing what’s available to investors, Bloomberg data show. The $5.5 trillion market includes securities guaranteed by government-supported Fannie Mae and Freddie Mac and U.S. agency Ginnie Mae.

Prepayments

Higher volatility harms mortgage-bond prices because it makes it more likely rates will fall or rise significantly, pushing refinancing and other sources of prepayments on the underlying loans either much higher or lower than expected.

Higher-than-expected prepayments typically return more of investors’ money when new investments carry lower yields, and may cause investors losses if they bought bonds above face value. Lower-than-expected refinancing causes investors to receive their money back slower than expected, as higher market yields make their investments less attractive.

Bloomberg current-coupon indexes represent the yields for hypothetical mortgage bonds trading at roughly face value. They are typically based on calculations derived from yields on the two groups trading just above and below par, into which lenders usually package new loans, because of the size of their coupons. Currently, they are based on 4 percent and 4.5 percent bonds.

The calm in the market for current-coupon bonds contrasts with the “wild” performance among contracts to buy and sell Fannie Mae securities with higher coupons in future months, as investors grapple with uncertainty about the company’s plans to buy delinquent loans out of the debt, according to JPMorgan.

Fannie Mae’s 6.5 percent 30-year securities for March delivery traded yesterday at 107.33 cents on the dollar, while similar securities for April delivery, which typically would cost less, traded at 107.48 cents, Bloomberg data show. The difference has narrowed 57 cents since March 1, when Fannie Mae said it would buy as many as 200,000 of the loans this month, as investors rethought the dispersion of its near-term buyouts across different coupons.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net