Mortgage Bond Returns Accelerate as Fed Moves Toward QE2: Credit Markets
Relative returns on government-backed mortgage bonds are showing investors have little confidence the Federal Reserve’s efforts to contain interest rates will break the gridlock in homeowner refinancing.
U.S. agency mortgage bonds returned 92 basis points, or 0.92 percentage point, more than similar government debt in October, Barclays Capital index data show. It was the second- best performance on record and the most since April 2008, the month after the nation’s central bank calmed markets with its rescue of Bear Stearns Cos.
While Fed support for debt markets has enabled a record $235 billion of high-yield corporate bond sales in 2010, homeowners are struggling to get mortgages with home-loan rates hovering near their lows. Speculation has dissipated that U.S. regulators or lawmakers will loosen refinancing standards for agency mortgages, a move that would punish bondholders by removing higher-rate loans from the securities sooner than anticipated.
“That had people concerned for about a month to six weeks, but nothing came of it,” said Chris Ames, a senior portfolio manager in New York for mortgage- and asset-backed securities at Schroder Investment Management Ltd. “Now people are more comfortable” with mortgage bonds trading for more than face value, he said. Investors get paid back at par when underlying mortgages are retired.
Debt in the $5.3 trillion market carries guarantees from government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae. The Fed purchased $1.25 trillion of the securities as it bought $1.7 trillion of debt through March. The central bank said in August it would begin reinvesting principal proceeds from those acquisitions into Treasuries.
The Fed will likely announce a plan today to purchase more Treasuries, according to a Bloomberg News survey of economists. Bond buyers may find additional reasons to purchase agency mortgage securities if the central bank fails to match investors’ expectations, said analysts at Barclays Capital, JPMorgan Chase & Co. and Nomura Securities International Inc.
Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of similar-maturity government debt fell 1 basis point to 164 basis points, down from this year’s high of 201 on June 11, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields averaged 3.45 percent, from 3.463 percent Nov. 1.
The cost of protecting bonds from default in the U.S. declined for a third day. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, decreased 0.1 basis point to a mid-price of 92.4 basis points as of 11:40 a.m. in New York, according to Markit Group Ltd. The index typically falls as investor confidence improves and rises as it deteriorates.
Credit 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.
Burlington Coat Factory Warehouse Corp., the Bain Capital LLC-owned operator of discount apparel, plans to sell $500 million of eight-year senior unsecured notes, the company said today in a statement distributed by Business Wire. Proceeds may be used to repay the company’s term loan facility, tender for outstanding debt and make a distribution to equity holders, according to the statement. Burlington Coat Factory is also seeking a $1 billion term loan to repay debt and for a dividend payment.
Before last month’s rally, agency mortgage bonds trailed Treasuries with maturities similar to their projected lives for two straight months, with the gap reaching 52 basis points in September, the most since November 2008, according to Barclays data that extends back to 1988. Excess returns this month total 11 basis points.
The rate at which homeowner refinancings and other prepayments paid down 30-year mortgages in Fannie Mae securities rose to a pace in September that would eliminate about 25 percent of the debt in a year, according to data compiled by JPMorgan based on reports released Oct. 6.
The so-called constant prepayment rate compares with the record of 60 in June 2003, as an almost 30 percent drop in home prices and tighter lending standards limit how many borrowers qualify for new loans. October reports are scheduled for release Nov. 4. The average rate on 30-year mortgages reached a record low of 4.17 percent in the middle of last month, according to Freddie Mac.
Wells Fargo & Co., the largest U.S. mortgage lender and second-largest servicer, is seeing the “widest ever spread” between current new-loan rates and those on the loans it manages for others, which averaged 5.46 percent on Sept. 30, Howard Atkins, the San Francisco-based bank’s chief financial officer, said on an Oct. 20 conference call.
Such disparities may eventually lead policy makers to address the refinancing hurdles, said Schroder’s Ames, whose firm oversees about 50 billion pounds ($80 billion) of fixed- income assets.
For the Fed, “refinancing borrowers is a nice ancillary benefit if it happens, but it’s not the main objective of another round” of quantitative easing, JPMorgan mortgage-bond analysts led by Matt Jozoff in New York wrote in an Oct. 29 report.
The central bank will probably introduce an unprecedented second round of unconventional monetary easing today by announcing a plan to buy at least $500 billion of long-term securities, according to 29 of 56 economists surveyed by Bloomberg News. All but three of the economists expect some plan for additional debt buying, with seven predicting $50 billion to $100 billion in monthly purchases without a specified total.
If the Fed surprises investors with a smaller-than- anticipated initiative, mortgage bonds may outperform Treasuries because it will add less relative demand for government debt and benchmark interest rates may rise, reducing the amount of homeowner refinancing that is moving debt from the central bank’s balance sheet to the market, Barclays analysts in New York led by Ajay Rajadhyaksha wrote in an Oct. 29 report.
Higher absolute yields may also “entice more banks” into mortgage securities, the JPMorgan analysts wrote. At the same time, recent climbs in interest rates are causing investors to begin to be concerned that mortgage securities will be repaid too slowly, rather than too quickly, and higher borrowing costs may spark more of that worry, they said.
If the central bank signals it may buy more than $600 billion of debt, the Fed may be forced to turn to securities aside from Treasuries because of a self-imposed limit in which it purchases no more than 35 percent of a particular issue, Nomura analysts led by Ohmsatya Ravi said. Agency mortgage securities would be “a natural choice,” they wrote Oct. 29.
The JPMorgan analysts also see an “increased possibility” the Fed may buy more mortgage securities because of the limit and because officials have indicated they will be watching mortgage-bond spreads. Still, the record failures of dealers to fulfill mortgage-bond sale contracts in a timely manner suggest the central bank may want to avoid further sapping supply from the market, they said.
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