Pimco’s Home-Loan Wager Seen as Prescient on QE3 Odds: Mortgages
Investors are positioning to benefit from a third round of debt purchases by the Federal Reserve, acquiring mortgage securities they’ll be able to sell to the central bank at higher prices.
Pacific Investment Management Co.’s Bill Gross raised mortgage holdings in the $258.7 billion Pimco Total Return Fund to 53 percent in April, the highest in three years, from 25 percent in July. A windfall would represent a repeat for the fund, which holds money ranging from individuals’ retirement accounts to institutional investments, following its outsized home-loan bets before the Fed acquired $1.25 trillion of mortgage bonds between January 2009 and March 2010.
Economists at Morgan Stanley, Bank of America Corp. and JPMorgan Chase & Co. see greater odds for a third round of asset purchases by the central bank known as quantitative easing, or QE3, as Europe’s leaders struggle to contain a sovereign debt crisis and the U.S. added 69,000 jobs in May, the fewest in a year. Morgan Stanley estimates the chances at 80 percent, up from 50 percent last month, and expects that the Fed would expand its mortgage bond holdings by about $200 billion.
Fed purchases of government-backed securities have “started to look a lot more likely over the last few weeks,” said Chris Kuehl, head of agency mortgage-backed securities for American Capital Agency Corp. (AGNC) at a conference hosted by Keefe, Bruyette & Woods Inc. in New York.
American Capital, the second-largest real estate investment trust that buys mortgage securities, has acquired lower coupon home-loan bonds that “will do fine” in the current environment. Under QE3, though, these are “the exact securities that we would expect that the Fed would purchase,” he said. “We would have an opportunity to sell these positions into the Fed at very inflated prices and reinvest in areas where the Fed is not participating.”
American Capital, based in Bethesda, Maryland, is run by former Freddie Mac investment chief Gary Kain and had $88.4 billion of assets on March 31. The firm said until a few weeks, while QE3 was possible, the odds were lower, amid moderate growth that would have been a “great environment” for mortgage holdings.
Pimco’s Gross has anticipated Fed action, writing “QE3 getting closer” in a Twitter message on May 8. Scott Simon, the Newport Beach, California-based company’s mortgage head, declined to comment yesterday. The Total Return Fund has returned 5.1 percent this year to beat 99 percent of competitors, according to data compiled by Bloomberg.
Investors stepped up speculation that any QE3 or similar program would include mortgage bonds after Fed Chairman Ben S. Bernanke sent a study to Congress in January that highlighted how housing is restraining the economic recovery.
Bernanke said today in testimony to the Joint Economic Committee in Washington that the U.S. economy is at risk from Europe’s debt crisis and the prospect of domestic fiscal tightening, while refraining from discussing steps the central bank might take to protect the expansion.
That followed comments by Vice Chairman Janet Yellen yesterday that weak job growth and deteriorating financial market conditions show the economy “remains vulnerable to setbacks” and may warrant more accommodation.
About 61 percent of money managers who responded to a survey a month ago by JPMorgan’s top-ranked mortgage-bond analysts said they were already “overweight” home-loan securities, or holding more than found in benchmark indexes. Fifty-two percent expected QE3 within six months, the poll found.
Todd Abraham, co-head of the government and mortgage-backed fixed-income group at Federated Investors Inc., said that the firm has recently gone from “neutral” to “slightly overweight” on agency mortgage bonds, debt guaranteed by taxpayer-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae. He sees “the odds of the Fed doing something” as having gone up this month.
The money manager’s additions of the debt have more to do with its “fundamental” value, he said. Still, there is “a little bit of a thought that if the things do get significantly worse, the Fed’s not going to stand idly by,” said Abraham, whose Pittsburgh-based firm manages about $364 billion of assets.
The Fed began reinvesting in the mortgage market with proceeds from its past purchases in October, acquiring $212.3 billion to offset repayments. It has targeted low-coupon bonds - - focusing recently on 3 percent and 3.5 percent 30-year securities -- because they most influence lending rates for consumers.
QE3 may involve about $200 billion in additional purchases over nine months, almost doubling the central bank’s reinvestment program, Morgan Stanley analysts Vipul Jain and Janaki Rao wrote in a June 1 report.
The Fed is limited because it wants to avoid disrupting “smooth market functioning,” they said. Its current buying accounts for 51 percent of the issuance of 30-year securities not set aside by lenders for investors who are willing to pay more for debt with steadier prepayments, they said.
QE3 could be about twice as big if the Fed acquires larger amounts of 15-year and Ginnie Mae debt. It has been buying a smaller share of those bonds than 30-year and Fannie Mae and Freddie Mac securities because the notes aren’t “as directly supportive of the policy goals,” according to the analysts.
Morgan Stanley recommended a “modest overweight” on Fannie Mae 3 percent and 3.5 percent notes relative to benchmark debt. Credit Suisse Group AG analysts led by Mahesh Swaminathan proposed a similar trade on the “likely buildup” to QE3 ahead of a June 19-20 meeting of Fed policy makers.
American Capital has purchased “generic” low coupon bonds while cutting so-called specified pools that offer prepayment protection, to a “majority” of holdings, from about 80 percent on Sept. 30, because of their high prices, Kuehl said. While the first type would do well in the current environment, if the Fed buys they’d do even better and serve to offset the “challenging” market created for higher coupon debt as lower rates boost prepayments, he said.
Fannie Mae’s 3.5 percent securities rose to a record 105.3 cents on the dollar on June 1, from less than 103 at the start of the year, amid gains in benchmark Treasuries, according to data compiled by Bloomberg. They’ve since fallen to 104.9 cents as of 11:50 a.m. in New York.
Jason Callan, head of structured products at Columbia Management Investment Advisers LLC, said that during a meeting this week his team considered adding low-coupon 30-year bonds as a bet on QE3. While the odds have risen, making it more likely than not, they weren’t yet ready to place the wager, he said.
“We’re as close as we’ve ever been to an explicit QE3 trade,” said Callan, whose Minneapolis-based firm oversees about $165 billion in fixed income. “Still, it’s far from a certainty that the Fed’s June meeting is going to end with QE coming out of it.”
Callan said in April that some investors were too quick to see diminished QE3 odds after a Fed statement said certain policy makers supported easing only “if the economy lost momentum.” QE3 probably wouldn’t provide much aid to the U.S. after previous Fed programs, he said this week. “At the end of the day low rates have done nothing to really stimulate a significant level of growth.”
The impact of QE3 for consumers may be eroded because lenders have little capacity to process additional home loans for refinancing, according to Amherst Securities Group LP analyst Laurie Goodman. That often leads originators to leave mortgage rates higher than bond yields suggest are possible, ballooning their profit margins.
“All you’re basically doing is writing a check to the large financial institutions,” she said at conference in New York for Bloomberg LP customers on May 17.
The difference between average rates on new 30-year loans and yields at which Fannie Mae will buy debt for its face value to package into securities has jumped in the past two months as bond yields fell to record lows, according to data compiled by Bloomberg. The gap expanded to more than 0.50 percentage point, from about 0.30 percentage point in late April.
While QE1 was extremely valuable after the global financial crisis roiled the mortgage-bond market, further buying could be disruptive and probably pointless for real estate because mortgage underwriting by banks is tight, Troy Dixon, co-head of securitized products trading at Deutsche Bank AG, said at the conference.
“The recovery of the housing market isn’t about affordability anymore, it’s about credit” being made available to more consumers, he said.
Still, $200 billion of additional Fed holdings would bring those of money managers and investors such as REITs close to “neutral” relative to benchmark indexes, according to Morgan Stanley, forcing them to invest elsewhere.
Redeploying cash during QE1, Gross boosted the Total Return Fund’s holdings of emerging-market debt to 6 percent, the most since 2008, and non-dollar bonds of developed nations to 18 percent as of March 2010, with investment-grade corporate bonds at 16 percent. The mortgage share fell to 16 percent, down from 81 percent in November 2008, when the Fed announced the program.
“We’ve exchanged our mortgages for the government’s check and now, we’re moving on,” Gross said in a September, 2009, interview with Bloomberg Radio.
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