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Risky Mortgage Securities Safer Haven as Europe Roils Markets

U.S. debt investors would have been better off eschewing high-yield company bonds in favor of risky mortgage securities before Europe’s sovereign-debt crisis intensified this quarter.

Speculative-grade U.S. corporate bond prices have declined 0.5 percent on average since March 31, Bank of America Merrill Lynch index data show. Mortgage debt, including senior-ranked securities backed by U.S. subprime home loans and some junior commercial issues, is still higher though off top levels this quarter, Barclays Plc and Markit Group Ltd. data show.

Mortgage securities, the biggest cause of investor losses in 2007 and 2008, have held up better than corporate junk bonds because of limited issuance and higher potential yields, even after both enjoyed record rallies from lows, said Scott Buchta, head of investment strategy at Guggenheim Securities LLC in Chicago.

“There’s replacement fear” dissuading holders from selling mortgage bonds as they consider what else they can buy, he said in a telephone interview. In addition, “there’s really no direct European exposure” with debt backed by U.S. properties, whereas some companies depend on sales from the region, he said.

Average prices for high-yield U.S. company bonds declined to 97.5 cents on the dollar on May 14, from 98.03 cents on March 31 and last month’s high of 99.67, on concern an almost $1 trillion European bailout package won’t prevent a sovereign debt default that might trigger a breakup of the euro, according to the Bank of America Merrill Lynch U.S. High Yield Master II Index.

High-yield, or junk debt is rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s.

Default Index

A Markit ABX index of credit-default swaps tied to 20 subprime-loan bonds rated AAA when created in the first half of 2007 has climbed by more 15.8 percent this quarter. Rising prices for the swaps generally indicate less pessimism about creditworthiness.

The index, which trades at levels similar to the prices of the underlying securities in cents on the dollar, rose to 46.75 on May 3, the highest since October 2008, after falling as low as 23.1 in April 2009. It stood at 42.75 on May 14.

Typical prices for the most-senior securities backed by option adjustable-rate mortgages rose last week to 59 cents on the dollar from 55 cents in the last week of March and a record low of 33 cents in March 2009, according to Barclays data.

Option ARMs allow borrowers to pay less than the interest they owe by increasing their balances, resulting in potential jumps in payments later on. Subprime mortgage were taken out by borrowers with poor credit or high debt.

Commercial Mortgage Debt

The lowest-ranked of originally top-rated commercial mortgage bonds, known as AJs, climbed to 54 cents on the dollar last week from 43 cents in the last week of March, according to Barclays data.

A top-ranked commercial-mortgage bond commonly cited as a market barometer is yielding about 3.9 percentage points more than the benchmark swap rate, according to Jefferies Group Inc. data. The so-called spread traded reached as wide as 4.2 percentage points over swaps on May 6, the day the Dow Jones Industrial Average fell as much as 9.2 percent, the data show.

So-called mezzanine bonds originally rated AAA but more vulnerable to losses than the most senior commercial-mortgage debt have fallen 2 percentage points on average since May 6 and are trading in the “mid” 80 cents on-the-dollar range, according to Jefferies.

Holders of mezzanine and junior AAA commercial mortgage-backed securities didn’t increase selling amid mounting risk aversion, JPMorgan Chase & Co. analysts led by Alan Todd in New York said in a May 7 report. Recent moves were less reflective of “widespread panic” and was more indicative of mortgage-backed securities “widening on the heels of increased geopolitical and regulatory risk,” the analysts said.

Spread over Treasuries

High-yield company debt on average offers 6.23 percentage points more than benchmark Treasuries, compared with 8.54 percentage points on AJ commercial mortgage securities, according to Barclays and Morgan Stanley indexes.

Among specific types of mortgage securities, “higher quality” bonds have done “much” better in weathering the sovereign debt crisis, though weaker debt is suffering mainly from wider gaps in the prices at which it can be bought or sold, Guggenheim’s Buctha said.

The high-yield company bond market may have been hurt more because it lacks as many “longer-term investors” such as insurers, “who aren’t looking for a trade but looking to buy and hold,” he said. “They’re not going to be as fast to sell.”

Barclays Recommendation

Since July 31, Barclays Capital analysts have recommended a trade in which investors hedge their bets on U.S. home-loan securities without government-backed guarantees.

New York-based analysts led by Ajay Rajadhyaksha suggested buying senior Alt-A mortgage bonds while using credit-default swap indexes to bet against commercial-mortgage bonds and high-yield corporate bonds.

That strategy has returned 19.2 percent since then, according to a May 14 report by the bank. Alt-A loans fall between prime and subprime in terms of projected defaults, often because borrowers didn’t document their incomes.

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