Government-backed mortgage bonds are beating corporate notes even as investors see shrinking odds the Federal Reserve will expand its holdings of U.S. housing debt.
When compared with similar-duration Treasuries, returns on the home-loan securities are exceeding U.S. investment-grade company bonds by 11 basis points since March, partly because a Fed purchase program for mortgages is limiting a decline in demand as low yields deter some investors. In the first quarter, excess returns on mortgage debt trailed those on corporates by 276 basis points, Barclays Plc index data show.
While the bond market is scrutinizing Fed officials for signs they’ll expand the central bank’s balance sheet with a third round of debt buying, a program to reinvest proceeds from past mortgage purchases is fueling record-low borrowing costs and aiding housing. This year’s tally of more than $110 billion represents almost a third of issuance in the 30-year notes being targeted, according to data compiled by Bloomberg.
“The Fed’s been a large factor in why we’re here and their influence is even greater as other buyers pull back at these low yields,” said Brad Scott, Bank of America Corp.’s head trader of pass-through agency mortgage securities. Scott worked on the central bank’s initial purchases of $1.25 trillion of the debt in 2009 and 2010 while at Pacific Investment Management Co.
Investors who drove a rally across credit markets in the first quarter are demanding higher relative yields on concern that Europe’s debt crisis is deepening and the U.S. recovery is faltering, or that bond rates are too low if conditions improve. Fannie Mae’s 3.5 percent securities, which package the most new home loans, dropped to a record low 2.53 percent as of 11:33 a.m. in New York.
The Fed is signaling it will wait to see whether to increase its balance sheet, with four district bank presidents casting doubt on the need on May 1. Earlier this year, central bankers were stressing the need to revive housing, with Chairman Ben S. Bernanke sending lawmakers a report on policy options.
Elsewhere in credit markets, a benchmark gauge of U.S. company credit risk rose, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing by 0.8 basis point to a mid-price of 99.6 basis points as of 12:14 p.m. in New York, according to prices compiled by Bloomberg.
That’s the highest level since April 25 on an intra-day basis for the index, which typically rises as investor confidence deteriorates and falls as it improves. 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.
Rate Swap Spreads
The U.S. two-year interest-rate swap spread, a measure of bond market stress, rose for a fourth day, climbing 0.8 basis point to 29.75 basis points as of 12:13 p.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.
Bonds of Fairfield, Connecticut-based General Electric Co. are the most actively traded U.S. corporate securities by dealers today, with 34 trades of $1 million or more as of 12:14 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Agency mortgage bonds have returned 1.45 percent this year to beat similar-duration Treasuries by 0.85 percent, the best start of a year since 2009, when the Fed began buying, Barclays data show. The gains are also being fueled by purchases by banks, whose holdings are up by about $70 billion, and real estate investment trusts, as both benefit from the Fed holding short-term borrowing costs near zero, central bank data show.
Returns on mortgage bonds have trailed behind government notes by 16 basis points from the end of March through last week, compared with an underperformance of 27 basis points for investment-grade company bonds, Barclays data show. In the first quarter, corporates outperformed by 377 basis points and mortgages by 101 basis points.
Mortgage-bond trading at the end of last week implied investors put the odds of a third round of so-called quantitative easing by the Fed, or QE3, at about 22 percent, less than half levels reached in February and March, according to Credit Suisse Group AG calculations.
The Fed’s monetary-policy panel said after its April 25 meeting it wasn’t changing its current program of reinvesting the $5.4 trillion market for mortgage bonds guaranteed by government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae.
Bernanke signaled in a news conference later that day that further Fed stimulus is unlikely unless the economy unexpectedly deteriorates, saying allowing inflation faster than its target would be “reckless.”
The central bank has bought $190 billion of mortgage bonds since October, after shifting from purchasing Treasuries with cash generated by homeowner refinancing, defaults and property sales. The plan was announced in September with its decision to sell $400 billion short-term government notes to buy longer-term ones in a program known as Operation Twist.
Unlike Operation Twist, which is scheduled to end next month, there’s no specified end date for its reinvestment programs.
The Fed is getting repaid on bonds backed by mortgages with higher rates, which are gaining as investors grow less concerned that they’ll be damaged from a faster pace of refinancing by homeowners amid record low borrowing costs and expanded Fannie Mae and Freddie Mac guidelines. The central bank is moving into the lower-coupon securities that guide new loans rates, which have fallen to 3.84 percent, according to Freddie Mac surveys.
The Fed has been “one of the largest contributing factors to the scarcity value” in the market, whose size has remained essentially unchanged since 2009, Glenn Schultz, Wells Fargo & Co.’s head of residential mortgage research, wrote in a May 2 report. Its recent buying has represented from 70 percent to 94 percent of new bonds daily, based on the amounts from originators reported to clients by dealers, he said.
While those figures tracking forward sales contracts tend to understate actual issuance volumes because banks retain some securities and individual dealers aren’t bidding on all of the debt, they underscore how traders and investors are viewing the size of the Fed’s presence.
“You look at what originators are making and what the Fed’s buying, and often it’s most of it, if not all of it,” Scott Buchta, the head of mortgage strategy at Sandler O’Neill & Partners LP, said in a telephone interview.
Bill Roth, co-chief investment officer of Two Harbors Investment Corp., a mortgage REIT, said lower-coupon bonds have “done well because of the buying but also partly because volatility has come down” as investors view the Fed as unlikely to raise short-term rates before 2014 and economic growth as subdued, leaving benchmark yields trading in a limited range.
The Bank of America Merrill Lynch MOVE Index, which measures volatility based on prices of over-the-counter options on Treasuries maturing in two to 30 years, fell to 57.8 basis points on May 4, the lowest since June 2007.
Higher forecasted rate volatility increases doubt about when mortgage debt will be repaid as projected homeowner refinancing fluctuates. Investors in bonds trading for more than face value because of their high coupons get damaged as prepayments return their cash faster at par and curb interest.
Fannie Mae’s 6.5 percent notes, backed by loans with rates averaging about 7 percent, rose last week to almost 113 cents on the dollar, the highest since July, according to Bloomberg data.
Gains accelerated after April 5, when monthly prepayment data signaled a limited pace of increasing use of Fannie Mae and Freddie Mac’s Home Affordable Refinance Program, or HARP, after changes begun in December.
“Investors keep pushing their timeframe for the HARP 2.0 impact out month-by-month,” Chad Stephens, a money manager in Atlanta at Stable River Capital Management, which oversees about $9 billion, said May 3. “I don’t think it’s going to be enough to dramatically move the needle, so I still like the up-in- coupon trade.”
Higher-coupon bonds, which carry shorter expected lives because of relatively higher projected combined default and refinancing rates, are also benefiting from investors’ desire to guard against higher yields, Bank of America’s Scott said.
Some asset managers are “weeding out the pools that they think are going to be the most adversely impacted” by HARP, such as ones serviced by particular banks, Buchta said. Still, they don’t want to sell too much because they are concerned it will be hard to find again and may also leave them betting too much that long-term rates will stay low, he said.
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