Mortgage Bonds Slump in U.S. as Policy Concern Trumps Analysis

Government-backed mortgage bonds are poised to underperform Treasuries this month by the most since the height of the global financial crisis, roiled by speculation about potential public policy changes and a wave of home refinancings spurred by record-low interest rates.

Securities guaranteed by government-supported Fannie Mae, Freddie Mac or federal agency Ginnie Mae returned 54 basis points, or 0.54 percentage point, less than U.S. debt this month, Barclays Capital index data show. It’s the worst relative performance since November 2008.

The $5.4 trillion market is being challenged by speculation the Federal Reserve may boost Treasury purchases and the U.S. may loosen Fannie Mae and Freddie Mac refinancing standards, Eugene Flood, chief executive officer of Smith Breeden Associates Inc., said Sept. 28 at Bloomberg News headquarters in New York. The Obama administration and lawmakers are also drawing attention to the companies’ undecided futures, he said.

“With all that uncertainty, it makes it difficult to invest through our traditional bottom-up analysis,” said Flood, whose Chapel Hill, North Carolina-based fixed-income firm oversees $8 billion. “We’d rather stay neutral to slightly defensive on the sector, rather than the overweights that we usually have.”

Reversal from First Half

Fannie Mae, Freddie Mac and Ginnie Mae’s so-called agency mortgage bonds beat Treasuries with similar expected durations by 119 basis points in the first seven months of this year as investors sought U.S. debt with little credit risk and higher yields than Treasuries amid Europe’s sovereign debt crisis.

In the past two months, investors in the home-loan securities have lost 0.25 percent even as Treasury prices rallied and in some cases pushed yields to record lows. Mortgage bonds trimmed this year’s returns to 5.09 percent, the data show.

The Fed said this month it’s willing to ease monetary policy further, after last month saying it would use proceeds from $1.25 trillion in mortgage bond holdings to buy Treasuries, a decision that helped shift relative demand for the two types of debt.

The further yields fall, the more of a “headwind” the mortgage-bond market faces from the “shadow inventory” of securities held by the Fed, JPMorgan Chase & Co. analysts in New York led by Matthew Jozoff wrote in a Sept. 24 report. Lower rates boost home refinancings as borrowers pay down loans within bonds owned by the Fed. The process also adds additional securities backed by new loans to the market.

Climbing Yields

Yields on Washington-based Fannie Mae’s 30-year, fixed-rate current-coupon securities have climbed from a record low of 3.29 percent on Aug. 31, according to data compiled by Bloomberg. Yields reached 3.45 percent as of 10 a.m. in New York, after falling from this year’s high of 4.67 percent on April 5. The current-coupon securities most affect home loan rates because they trade closest to face value.

The difference between yields on the debt and 10-year Treasuries widened to 89 basis points, up from 82 basis points on Aug. 31 and a record low of 54 basis points on July 30, Bloomberg data show.

The average rate on a 30-year mortgage matched a record low 4.32 percent this week, according to McLean, Virginia-based Freddie Mac. Rates near record lows helped push a Mortgage Banker Association index of refinancing applications to the highest in almost 16 months.

Refinancing Hurts

Mortgage refinancing can hurt bondholders by returning their money more quickly than anticipated and depriving them of expected interest payments. That’s particularly punitive if investors paid more than face value for their securities as they sought relatively high coupons.

August prepayment reports showed mortgages with relatively low rates refinancing faster than some analysts expected, in some cases outpacing refinancings on higher interest loans.

Legislation announced by California Democratic Congressman Dennis Cardoza reminded bondholders that policy makers may seek to help borrowers previously blocked from refinancing because the value of their homes has fallen too much or because they don’t meet tighter lending standards enacted by banks after the financial crisis.

“Nothing would provide a quicker, substantive boost to the weak recovery than more refis,” Cardoza said in a Sept. 29 statement about his push to streamline refinancing requirements and cut borrower fees for Fannie Mae and Freddie Mac loans.

Congress this month also held two hearings on the future of the U.S. mortgage-finance system, focusing on Fannie Mae and Freddie Mac, which have drawn almost $150 billion of taxpayer capital since being seized in 2008. Treasury Secretary Timothy F. Geithner, who last month said the U.S. won’t back away from its companies’ obligations, promised to deliver a plan for them in January.

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