Mortgage Bonds Stare Down End of QE as Gains Persist

The end of the Federal Reserve’s third round of bond purchases is proving to be a non-event for mortgage-backed debt.

That’s partly because even though the U.S. central bank won’t be adding more home-loan securities to its balance sheet, policy makers will still be buying enough to prevent its holdings from shrinking. Those purchases are having a greater impact as the pace of net issuance slows to a quarter of the amount last year amid a weaker property market.

The $5.4 trillion market for government-backed mortgage bonds is defying predictions for a slump tied to the wind-down of the Fed stimulus program, whose completion was announced today. Yields on benchmark Fannie Mae notes have shrunk 0.17 percentage point this year relative to government debt, narrowing to within 1.05 percentage points of an average of five- and 10-year Treasury rates.

“This strong performance was in sharp contrast to the consensus view at the beginning of the year,” Gary Kain, president of Bethesda, Maryland-based American Capital Agency Corp., said yesterday on an earnings call.

The Fed’s asset purchases are “essentially done at this point and the mortgage market remains well supported,” said Kain, whose firm is the second-largest real-estate investment trust that buys home-loan debt.

Tighter Spreads

The yield spread on the Fannie Mae securities is 0.46 percentage point less than the average during the past 15 years as of 3 p.m. in New York, according to data compiled by Bloomberg. It’s also 0.08 percentage point tighter than when the Fed started its third round of quantitative easing, known as QE3, in September 2012.

The U.S. central bank has also been buying Treasuries under the program, which has swelled its balance sheet by $1.66 trillion to a record $4.48 trillion. The Fed said last month it will keep buying enough mortgage bonds to maintain the size of its holdings, which total $1.71 trillion excluding some unsettled purchases, until after policy makers start raising their benchmark interest rate.

Money markets are now predicting that won’t happen until the end of next year after the recent global economic and political turmoil pushed out expectations for a tightening.

Fed Buying

While the Fed “will still be in the market for some time” with its reinvestments, more demand from investors will need to emerge in the longer run to offset the exit of the market’s biggest buyer, said Kevin Grant, chief executive officer of Waltham, Massachusetts-based CYS Investments Inc.

“We don’t know who that is and the market probably does not need that buyer right now given the low supply, but eventually the market will need that new buyer,” Grant said on the mortgage REIT’s Oct. 21 earnings call.

The central bank’s reinvestments absorb about $20 billion of mortgage securities each month, according to BNP Paribas SA estimates, limiting supply now amid what is a seasonal slowdown. BNP Paribas predicts the debt will outperform and reiterated its recommendation today after the Fed statement.

“As we are entering seasons where purchase activity and net issuance declines, this lack of supply should be more pronounced,” BNP Paribas analyst Anish Lohokare wrote in an Oct. 23 report.

Net issuance, or sales adjusted for the repayment of outstanding debt, fell to $47 billion in the first nine months of 2014, and will probably reach $62 billion for the year, according to Citigroup Inc. analysts led by Ankur Mehta.

Home Sales

That’s about a quarter of the $245 billion issued last year, reflecting an uneven recovery in the housing market and banks that are retaining more loans instead of selling them by packaging them into securities.

Home resales haven’t regained their 2013 peak as tepid wage growth and tighter credit restrain purchases. Contracts to buy existing homes rose less than forecast in September, after dropping 1 percent in August, the National Association of Realtors said Oct. 27.

Growth of the agency mortgage-bond market will remain a fraction of 2013’s pace next year at $75 billion as the housing market only shows “some improvement,” the Citigroup analysts forecast. Agency mortgage bonds are those guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.

Debt Gains

Muted supply and a potentially longer time-line for near-zero interest rates from the Fed may bode well for home-loan securities.

Agency mortgage bonds have returned 5.4 percent this year through Oct. 27, gaining 0.5 percentage point more than similar-duration U.S. government notes, according to Bank of America Merrill Lynch index data. The debt lost 1.4 percent last year, its first annual decline since 1994.

“The end of QE3 didn’t create the dislocations” that “some people expected,” said American Capital Agency’s Kain, whose REIT has almost $70 billion of mortgage-bond investments and is among firms using borrowing based on short-term rates to invest in the market. Furthermore, “there’s a greater probability that the Fed is now going to be on hold for multiple years.”

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