Relative yields on U.S. government-backed mortgage bonds are at about the lowest in almost five months as Federal Reserve Chairman Ben S. Bernanke proves more important to the market than Tea Party politicians.
Yields on benchmark Fannie Mae securities dropped last week to 1.28 percentage points more than an average of 5- and 10-year Treasury rates, the narrowest since May 22, according to Bloomberg index data. The spreads, which advanced yesterday to 1.31, have fallen from a 15-month high of 1.51 reached in July, two months before the Fed surprised investors by maintaining its $40 billion of monthly purchases of housing debt.
Investors from TCW Group Inc. to Prologue Capital Inc. say it’s no time to bet against the $5.3 trillion market even as JPMorgan Chase & Co. and Barclays Plc analysts warn the securities are too expensive and the Treasury Department cautions that spreads could jump if Congress doesn’t act soon to expand the nation’s debt limit. Speculation is growing that the Fed will further extend bond purchases that represent about 70 percent of new issuance and have left it with $500 billion more of the debt than when a stalemate roiled markets in 2011.
“The messier it gets, the larger the markets believe the dose of medicine from the Fed will be,” said Bryan Whalen, co-head of mortgage bonds at Los Angeles-based TCW, which oversees about $130 billion. “We just saw their willingness to behave that way by not tapering.”
U.S. money managers that own about $860 billion of agency mortgage debt will need to see more evidence that the central bank is gearing up to scale back its purchases before they cut allocations to the market, according to Nomura Securities International analysts led by Ohmsatya Ravi.
While the investors hold $150 billion less than when the Fed started expanding its bond buying 13 months ago, they’re maintaining a so-called neutral position that’s consistent with the percentages found in benchmark bond indexes, the analysts said in an Oct. 4 report.
If the showdown between President Barack Obama and Tea Party-backed Republicans escalates to the same degree as the 2011 fight that prompted Standard & Poor’s to strip the U.S. of its AAA rating, mortgage bonds would probably lag behind Treasuries in “a flight-to-quality rally,” said Noah Estrin, a portfolio manager at Greenwich, Connecticut-based hedge fund Prologue Capital, which oversees about $2.3 billion. For now, the battle is now boosting their appeal, he said.
“The government shutdown and debt-ceiling debate is obviously going to keep the Fed a little more defensive,” Estrin said. “While I thought they were going to taper this year, I’m becoming more skeptical on that.”
Elsewhere in credit markets, the cost to protect against losses on corporate bonds in the U.S. rose for a second day to a more than three-week high. Deutsche Telekom AG, Germany’s biggest phone company, is planning to sell $5.6 billion of T-Mobile USA Inc. (TMUS) notes. Hudson’s Bay Co. set the rate on a $2.3 billion of loans backing its acquisition of Saks Inc.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, fell 0.98 basis point to 11.88 basis points, the lowest this year. The gauge typically narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, increased 2 basis points to a mid-price of 84.5 basis points, according to prices compiled by Bloomberg. That’s the highest since Sept. 13 in data that adjusts for the effects of the market’s shift to a new version of the index last month.
The Markit iTraxx Europe Index of 125 companies with investment-grade ratings fell 0.8 to 99.8 at 10:45 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan increased 1.8 to 151.
The indexes typically increase as investor confidence deteriorates and fall as it improves. 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.
Bonds of Verizon Communications Inc. (VZ) were the most actively traded dollar-denominated corporate securities by dealers yesterday, accounting for 5.1 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The New York-based telephone carrier raised $49 billion on Sept. 11 in the largest corporate bond issue ever.
The debt being sold by Deutsche Telekom, which controls T-Mobile, is part of an $11.2 billion private placement of notes T-Mobile issued to the company in April as part of its merger with MetroPCS Communications Inc., according to a regulatory filing yesterday.
The offering includes $1.25 billion in 6.542 percent notes due in 2020 and $1.25 billion of 6.731 percent securities that mature in 2022, according to a person with knowledge of the offering who asked not to be identified because terms aren’t set. T-Mobile said in a filing earlier that the company planned to offer a total of $3.1 billion.
The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index rose 0.01 cent to 97.51 cents on the dollar. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has returned 3.32 percent this year.
Leveraged loans and high-yield, high-risk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.
Hudson’s Bay (HBAYF), Canada’s largest department-store operator, will pay 3.75 percentage points more than Libor for a seven-year, $2 billion term loan and 7.25 percent more than the benchmark for a $300 million junior loan, according to a person with knowledge of the offering. Both borrowings will have a 1 percent minimum on Libor, said the person, who asked not to be identified without authorization to speak publicly.
‘Close to Home’
U.S. agency mortgage-bond analysts at JPMorgan led by Matt Jozoff, the top-ranked team for the debt in this year’s Institutional Investor poll, and Barclays’s No. 3 rated researchers led by Nicholas Strand recommend that investors take an “underweight” position in the notes, or a smaller percentage than is contained in benchmark indexes. The spreads are too tight to be sustainable with the Fed set to eventually slow and then end purchases, they each said in Oct. 4 reports.
Relative yields on the Fannie Mae debt are currently about 0.15 percentage point less than the 1.46 percentage-point average over the past decade and compare with a three-month low in May of 1.14 percentage points, according to Bloomberg data.
Nomura’s second-ranked team says investors should remain “neutral” for now, with the odds that the central bank postpones a stimulus reduction until next year “gradually increasing.” Prologue’s Estrin said he’s generally maintaining a neutral position, while Whalen said TCW is “as close to home right now as I can remember us being in the last few years.”
The political standoff is creating an additional danger, according to the JPMorgan analysts.
“Most risky assets (including mortgages) would significantly underperform in the near-term in the unlikely event of a default” by the government, they wrote in the report last week.
The Treasury Department, in a paper released Oct. 3, cited the widening of mortgage spreads in 2011 in saying that “political brinksmanship that engenders even the prospect of a default can be disruptive to financial markets and American businesses and families.”
As U.S. lawmakers fought over the debt ceiling two years ago and S&P then downgraded the government to AA- on Aug. 5, spreads on the Fannie Mae securities climbed to a more than two-year high of 1.9 percentage points the next week, from 1.57 percentage points in July 2011, Bloomberg data show.
“If the widening of mortgage spreads that resulted from the debt ceiling debate were to take place now, when yields on Treasury securities have been rising, the result would be higher mortgage rates that would restrain the housing market and household spending,” the Treasury said in its report.
The report didn’t note the drop in government-debt yields during the standoff this year, with yields on 10-year notes, a benchmark for everything from corporate bonds to mortgage rates, reaching a two-month low of 2.59 percent on Oct. 3. Investors from Estrin to Christopher Sullivan, who oversees $2.2 billion as chief investment officer at United Nations Federal Credit Union in New York, said that a default may cause Treasury yields to decline further, as they did in August 2011.
Borrowing costs are already paring a jump that pushed them to a more than two-year high in August. The average rate offered on new 30-year fixed home loans fell to 4.22 percent last week, after reaching 4.58 percent on Aug. 22 from 3.35 percent in early May, according to Freddie Mac surveys.
While the increase in rates choked off most homeowner refinancing, the Fed’s purchases are accounting for a growing share of issuance with sales of new debt slowing. Monthly issuance is set to fall to $70 billion to $75 billion, down from an average of about $150 billion since last June, according to Morgan Stanley analysts including Vipul Jain.
In addition to the $40 billion of bonds the Fed adds to its balance sheet each month, it has also been purchasing $31 billion under a program in which it reinvests proceeds from previous purchases, a figure set to fall to $10 billion to $15 billion with as prepayments decline, Morgan Stanley estimated in a report last month.
The Fed began the reinvestment program in September 2011, after S&P’s U.S. downgrade roiled markets. The central bank’s additions to its holdings since September 2012 have expanded its portfolio to $1.34 trillion, surpassing a previous peak of $1.13 trillion reached in June 2010 after an earlier round of buying initiated during the financial crisis sparked by Lehman Brothers Holdings Inc.’s failure five years ago.
Investors now have less to sell. In the week before the Fed’s Sept. 18 announcement that it would maintain the current pace of its purchases, about 20 percent of investors surveyed by JPMorgan were “overweight,” the lowest level in two years. That was down from more than 60 percent before the start of Fed purchases and 50 percent in mid-2011.
‘Paid to Wait’
Money managers, banks, overseas investors, real-estate investment trusts and government-sponsored companies such as Fannie Mae have all reduced their holdings during the current round of purchases, even as the market grew by $170 billion, according to Nomura.
William Irving, a fixed-income manager at Fidelity Investments, which oversees $1.8 trillion, is now mostly avoiding the debt, he said. Along with historically tight spreads based on their expected payments over the long term, several types of mortgage bonds return less each month than similar-duration Treasuries, after accounting for expected rate volatility, he said.
“I’m paid to wait” before investing, he said in a telephone interview from Merrimack, New Hampshire. At the same time, “the risk is asymmetric, with there being more potential for spread widening than spread tightening,” he said.
That type of positioning is why it will be hard for spreads to widen so long as the Fed is buying, Prologue’s Estrin said.
“The sellers are exhausted,” he said. “There’s just not enough mortgages right now.”
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