TCW’s Flack Says He’s Cutting Back on MBS Before Fed Does

Fed's Balance Sheet

Mitch Flack at TCW Group Inc. is trimming back on mortgage-backed securities as he prepares for a volatile year.

While bond investors gird themselves for the Federal Reserve’s first increase in benchmark interest rates in almost a decade, those like Flack who focus on agency mortgage-backed securities are especially concerned about what policy makers do after liftoff: the unwinding of the Fed’s balance sheet, including its $1.72 trillion in MBS.

“This is going to be very complicated for the Fed, and there’s a heightened risk that it doesn’t go as planned,” said Flack, co-head of securitized products at TCW in Los Angeles. “We’re becoming more defensive and more selective in the mortgages we own.”

As the Fed reduces its $4.5 trillion portfolio, MBS investors can expect a double dose of volatility as soon as the end of this year. The Fed holds about 20 percent of marketable U.S. Treasuries and about 30 percent of the agency fixed-rate MBS market. Since mortgage securities trade at a spread over Treasuries, their yields will get bumped twice as the Fed reduces its balance sheet. Homebuyers will also face higher mortgage rates.

The effect of the Fed’s trimming will be magnified by the large role that mortgage securities play in the Barclays U.S. Aggregate Index, the most popular benchmark for investors in dollar-denominated debt.

“How the Fed ends reinvestments of MBS can have material implications for fixed-income investors, especially considering that agency MBS account for almost a third of the Barclays Aggregate Index,” Mike Cudzil, who specializes in mortgages at Pacific Investment Management Co., said in a March 18 blog post.

Ending Reinvestments

Fed officials are likely to begin pulling back from the most accommodative and unorthodox monetary policies in its history starting this year. Policy makers said they will lift rates in 2015 if unemployment continues to fall and inflation shows signs of rising toward their 2 percent target. After an initial rate hike, officials at some point plan to begin reducing their balance sheet by no longer reinvesting in Treasuries and MBS.

Flack helps manage the $65.7 billion Metropolitan West Total Return Bond Fund, which beat 93 percent of competing funds over the past five years, returning 5.7 percent annually.

Regulatory filings show the fund was still slightly overweight in agency MBS relative to the Barclays index as of March 31. It held 29 percent of its assets in those securities on that date, compared to 23 percent in the benchmark. Flack said the fund’s MBS has since dropped “modestly” under the index weighting.

Beating Rivals

Policy makers are in uncharted territory in unravelling a balance sheet that had never exceeded $1 trillion prior to the financial crisis. Shortly before lowering short-term rates to near zero in December 2008, the Fed began using bond purchases to press down longer-term yields in a bid to further stimulate the economy. The quantitative easing ended in October 2014.

The Fed owned $2.46 trillion in Treasuries as of May 14 and is keeping its holdings steady by reinvesting the money it receives when bonds mature or when mortgages tied to its MBS holdings are paid off early. That still makes the Fed a leading source of demand, gobbling up $150 billion to $250 billion a year in new mortgages.

“That’s a very significant amount of mortgages that have to be purchased by other entities” after the Fed withdraws, Flack said. “That could be daunting unless spreads widen.”

Mortgage Rates

Spreads could “easily” widen 15 to 30 basis points, said Anup Agarwal, head of mortgage and asset-backed securities at Western Asset Management Co. “That’s pretty dramatic for the marketplace.”

The average yield on benchmark 30-year MBS backed by Fannie Mae was 2.82 percent on May 15.

As lenders increase mortgage rates with widening spreads, some borrowers will be shut out of the housing market, said Mark Zandi, chief economist of Moody’s Analytics Inc. A half-a-percentage-point increase in a 30-year fixed mortgage’s interest rate adds about $120 to the monthly payment for a $300,000 loan.

That increase can be enough for lenders to deny borrowers a mortgage as wages remain stagnant for most Americans.

“Until we start to see meaningful growth in wages, homebuyers who are at the margins are going to be particularly vulnerable to rising mortgage rates,” Zandi said.

Investors are concerned that higher yields will spur more volatility before eventually providing buying opportunities as prices drop. A sharp rise in yields and mortgage rates tends to slow homeowner refinancing, while a fall in borrowing costs has the opposite impact. Such ups and downs in refinancing mean less predictable cash flows for investors, Flack said.

More Volatility

“Volatility is not the friend of the MBS investor,” Flack said.

Most Fed watchers prefer that the Fed will wait several months after the first rate rise to begin reducing its reinvestments, and do it gradually rather than shutting off the tap all at once.

“I expect they’ll say they will taper slowly, but the reality is the market will treat it as if it will end, and end soon,” Agarwal said. “Our worry is that when that happens, that will have pretty drastic impact.”

The Fed has assured investors it will not sell securities into the market when it decides to slim its balance sheet.

Slow Growth

“The committee indicated that we will eventually cease reinvestments or diminish the pace of reinvestments as a way of gradually reducing the size of our portfolio over time,” Fed Chair Janet Yellen said during a March 18 press conference.

With a weak start to 2015 for the economy -- first quarter GDP was just 0.2 percent -- economists have moved back their forecasts for a rate rise. A Bloomberg {survey} shows just 15 percent of respondents now believe liftoff will occur before September compared with 61 percent in January.

Investors say the slower the better when it comes to trimming the balance sheet.

“We’re aided if the Fed tapers slowly, we’re aided if the Fed delays the timing,” Flack said. “And if they communicate it well, it can buffer any dramatic price moves.”

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