Mortgage Rate-Yield Gap Eases Selloff in Bonds: Credit Markets

Interest rates on new U.S. home loans are rising slower than yields on the mortgage securities they’re packaged into, helping to contain an increase in borrowing costs across debt markets.

The gap between the cost of 30-year loans and benchmark Fannie Mae yields, a measure of lenders’ profit margins called the primary-second spread, has tightened to about 0.9 percentage point, compared with a two-year high of more than 1.3 percentage points in January, according to data compiled by Bloomberg.

The U.S. bond market is poised for its biggest monthly loss since the end of 2010 as a strengthening economy prompts traders to move up forecasts for when the Federal Reserve will raise interest rates to 2013 from 2014. Mortgages are helping to temper the selloff as lenders seek to maintain volumes by limiting increases in what they charge. Originators had raised margins to avoid being overwhelmed by demand when the government expanded eligibility with borrowing costs at record lows.

With rates rising, “there is going to be a little more capacity so you can have the primary-secondary spread come back in,” said Chris Flanagan, the New York-based head of securitized debt research at Bank of America Merrill Lynch.

Along with reducing the damage to housing, that’s also limiting changes this month to the projected lives of the $5.4 trillion in government-backed mortgage bonds caused by a decline in estimates for refinancing. That’s curbing the rebalancing of interest-rate hedges by owners and loan servicers that typically follows, according to reports from JPMorgan Chase & Co., Morgan Stanley and Nomura Securities International.

Convexity Trading

Such sales can send Treasury rates higher while widening relative yields on home-loan bonds and interest-rate swaps, a spiral that Bank of America Merrill Lynch says is close to starting.

“We’re not that far off of it given how much we’ve moved already,” Flanagan said in a telephone interview. Lending rates rising by another 0.15 percentage point to 0.25 percentage point may accelerate trading tied to so-called convexity, he said.

Elsewhere in credit markets, a measure of corporate credit risk in the U.S. rose, with the Markit CDX North America Investment Grade Index Series 18, a new version of the credit-default swaps benchmark that began trading yesterday, climbing 2.3 basis points to 89.2 basis points as of 12:24 p.m. in New York, according to Markit Group Ltd.

Bondholder Protection

The index 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.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, added 0.44 basis point to 26.69 basis points as of 12:27 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 Charlotte, North Carolina-based Bank of America Corp. are the most actively traded U.S. corporate securities by dealers today, with 122 trades of $1 million or more as of 12:28 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Yields on Fannie Mae’s current-coupon mortgage bonds, or those that most affect borrowing costs because they trade closest to face value, climbed to a four-month high of 3.24 percent as of March 19 from 2.46 percent on Jan. 31, a record low, Bloomberg data show. They’ve declined to 3.13 percent as of 12:03 p.m. in New York.

New loans average 4.05 percent, compared with a record low 3.81 percent on Feb. 15, according to data.

Refinancing Applications

Even as President Barack Obama and Fed Chairman Ben S. Bernanke seek to stoke the economy by helping homeowners tap lower rates, refinancing applications fell last week by 9.2 percent, according to a Mortgage Bankers Association index released yesterday. While that’s the biggest drop since November, volumes remain at about double last year’s lows in February.

The higher borrowing costs follow a government effort to encourage refinancing among homeowners who couldn’t previously qualify or benefit. Guidelines for loans with little or no home equity began changing at government-supported Fannie Mae and Freddie Mac in December, while adjustments to the Federal Housing Administration’s premium rules were announced March 6.

Applications under the federal Home Affordable Refinance Program for Fannie Mae and Freddie Mac loans account for about 30 percent of refinancing attempts at “some of the largest institutions,” Jay Brinkmann, the mortgage-banker group’s senior vice president of research and education, said in a statement.

Fed Rate Move

The gains in rates and yields are being driven by losses on benchmark U.S. government notes, which total 1.46 percent this month, the most since December 2010, according to Bank of America Merrill Lynch’s U.S. Treasury Master index.

Bonds in the U.S. have lost 0.83 percent this month, the most since declining 1.09 percent in December 2010, Bank of America Merrill Lynch index data show.

Forward markets for overnight index swaps, whose rate shows what traders expect the federal funds effective rate to average over the life of the contract, signal a quarter-percentage advance in approximately October 2013, Bloomberg data show. Last month, such an increase in the effective rate wasn’t predicted until early 2014.

While 10-year Treasury yields have climbed 33 basis points this month through yesterday to 2.30 percent, the rebalancing of hedges by mortgage-bond investors and servicers helped propel an advance of 90 basis points in July 2003 as mortgage rates moved up from then-record lows.

Mortgage Bond Returns

Convexity is a measure of the rate of change of a bond’s duration as a result of changes in interest rates. Duration is a measure of a bond’s price sensitivity to rate changes.

Mortgage bonds are negatively convex because their projected lives extend as rates rise, partly because refinancings will decline.

As higher rates leave investors and loan servicers with portfolios of longer-than-expected durations, they often sell mortgage bonds, Treasuries or interest-rate swaps to rebalance. Those sales can send yields even higher or spreads wider.

With convexity selling in check, government-backed mortgage bonds have returned 61 basis points more than similar-duration Treasuries through yesterday, the most since December 2010, Barclays Capital index data show.

Higher yields are bringing in new purchasing by banks, insurers and real estate investment trusts, and will attract such buying until more investors grow concerned that the Fed is planning to raise short-term rates sooner than pledged, said Deepak Narula, the head of hedge fund Metacapital Management LP in New York, which manages about $1 billion.

Rate Increases

“There’s a fairly large investor base that’s yield-driven that’s sitting on a lot of cash right now,” Narula said.

Ten-year Treasury yields would have to reach about 2.5 percent to drag loan rates to a level that would be “critical” in accelerating convexity-related selling, according to Morgan Stanley analysts including Vipul Jain and Janaki Rao.

Cumulative rebalancing needs since rates began climbing would then reach the equivalent of needing to sell $100 billion of the government debt, they said in a March 16 report.

While Fannie Mae and Freddie Mac no longer contribute as much to such waves after shrinking the amount of debt they hold, the next one may have “no less severe” an effect on mortgage-bond spreads when it occurs, according to Nomura Securities International analysts including Ankur Mehta and Ohmsatya Ravi.

‘Next Leg’

That’s because “dealer balance sheets are very limited,” leaving them less able to absorb a spike in supply, they wrote in a note to clients. The growth of REITs that buy fixed-rate mortgage securities has also offset some of the contraction at Fannie Mae and Freddie Mac, they said.

JPMorgan analysts led by Matt Jozoff wrote in a March 16 report that “the mortgage market may be vulnerable to further increases in rates from here, particularly if servicers capitulate.”

An increase may boost the value of servicers’ contracts past thresholds that can increase how much capital that banks need to hold against them, the analysts said. Servicers may lower the prices they pay for the asset as a result, boosting rates, as well as rebalancing hedges, they said.

Mortgage bonds may also suffer with “the next leg” higher in borrowing costs because even investors who don’t hedge their portfolios would become concerned about their growing durations, said Paul Jacob, the director of research at broker Banc of Manhattan Capital in Calabasas, California. The extension risk would come with a larger group of bonds falling below face value.

“From here, it gets dicier,” he said. “People fear the unknown and right now the unknown is a discount-priced MBS.”


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