Mortgage-Bond Yield Spreads Approach Lowest Level on Record

Yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates approached record lows relative to Treasuries as evidence of climbing borrowing costs and homeowners’ refinancing difficulties reduce concern that supply will increase.

Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds narrowed 0.03 percentage point to about 0.65 percentage point more than 10-year Treasuries as of 4:45 p.m. in New York, according to data compiled by Bloomberg. The gap reached 0.59 percentage point on March 29, two days before the Federal Reserve ended its buying of $1.25 trillion of home-loan debt.

Foreign investors such as central banks have been flocking to so-called agency mortgage bonds and debt as a haven, boosting holdings by more than $50 billion this year, according to Fed data. Mortgage rates may be rising from record lows and bond- prepayment reports released July 7 show limited refinancing, suggesting there will be less new supply to meet demand as borrowers pay off loans within bonds held by the Fed.

“The Fed’s going to take that cash and they’re not going to reinvest it,” said Paul Norris, a senior money manager at Dwight Asset Management Co. who oversees about $15 billion at the Burlington, Vermont-based company that he joined last year from Washington-based Fannie Mae.

JPMorgan Chase & Co. analysts led by Matthew Jozoff predicted in a July 9 report that about $125 billion to $150 billion of debt will come to the market from the Fed’s portfolio over the next year “at these rate levels.”

Fannie Mae Yields

While numerous factors are set to restrain mortgage-bond spreads, “refi-driven supply is the ‘fly in the ointment,’” they wrote. Jozoff declined to comment further today.

Yields on the Fannie Mae bonds have advanced to 3.77 percent from a record low of 3.63 percent reached July 6, down from 4.67 percent on April 5, Bloomberg data show. The gain has been slower than benchmark Treasuries, whose yields have begun rising as stocks rally, damping demand for the safest assets.

Spreads on the securities, which have fallen from 0.82 percentage point on June 30, today reached the lowest level since April 15.

Bond investors are finding “the alternatives away from the mortgage market” less attractive, Brett Rose, an analyst at Citigroup Inc., said in a telephone interview.

Reasons include a narrower difference between yields on shorter- and longer-term Treasuries that’s shrinking their potential to earn more by buying longer-dated debt, and concern that corporate bonds will remain volatile, Rose said.

Market Contraction

The $5.2 trillion market for agency mortgage securities is made up of those guaranteed by government-supported Fannie Mae and Freddie Mac, and federal agency Ginnie Mae. Current-coupon bonds, or those trading closest to face value, are guiding rates on almost all new U.S. home lending following the collapse of the non-agency market and a retreat by banks.

“One of the reasons they’ve done well is because they’re a high quality, higher yielding asset class,” said Curtis Arledge, chief investment officer of fixed income at New York- based BlackRock Inc., the world’s largest money manager. “That’s what has been most in demand since mid-April”

Supply also may be restrained by the limited amount of loans for home purchases, rather than refinancing, being taken out. Applications for such financing is holding near the lowest levels since 1997 after the expiration of tax credits, according to the Washington-based Mortgage Bankers Association.

Issuance May Rise

At the same time, the conclusion of programs in which Fannie Mae and Freddie Mac bought delinquent loans out of their securities is likely to help boost net issuance to an average of $27 billion in the next three months, according to a report yesterday by New York-based Citigroup analysts.

The market contracted by $3 billion in June, after shrinking by at least $28 billion in each month since February, they said. Gross issuance, which doesn’t take into account the dynamic in which refinancing means some debt is returning to the market, may average $106 billion over the next three months, up from $98 billion in June, they said.

While prepayment speeds for lower-coupon, more recently issued securities turned out to be faster than expected in June, those for other bonds were slower, which “underscores the dichotomy in the mortgage market right now” in which a record U.S. housing slump has left many borrowers unable to qualify for refinancing, said Brad Henis, an analyst at the bank.

“The fact is that prepayment risk has been lower because homeowners don’t have equity appreciation in their homes, so they’re not as quick to refinance,” Arledge said. “The prepayment option that you’re short when you buy mortgages has not been worth as much.”

Average Mortgage Rate

The average rate on a typical 30-year fixed-rate mortgage tumbled to a record low 4.57 percent in the week ended July 8, down from this year’s high of 5.21 percent in April, according to McLean, Virginia-based Freddie Mac.

Agency debt aside from home-loan securities also has benefited from increased foreign interest in relatively safe dollar-denominated debt with greater yields than Treasuries after markets were roiled by Europe’s sovereign debt crisis and signs the U.S. economic recovery is faltering.

When Fannie Mae sold $6 billion of its benchmark corporate notes on July 8, central banks and foreign investors made up the largest share of buyers in two years. Central banks, which don’t include the Fed, bought 55 percent of the debt, up from 36 percent in its last sale of similar securities on May 19, according to the company.

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

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