Avoid Securitized-Debt Risk on Chance of 2008 Repeat, Bank of America Says
Investors should avoid taking risk in all categories of U.S. securitized debt because American and European policy makers may damage financial markets as they respond to a slowing economy and government deficits, according to Bank of America Merrill Lynch analysts.
“Rather than a repeat of 2010, when the Fed saved the day with QE2, we think we are moving closer to a repeat of 2008, when major policy errors devastated the economy,” the analysts led by Chris Flanagan wrote in an Aug. 19 report. “The pressure to ‘do something’ is now far more likely to result in more desperate or radical measures, even if it is bad policy.”
Credit markets have been roiled by concern that the U.S. may slip back into recession and that Europe can’t contain its sovereign-debt crisis. The cost of protecting U.S. corporate bonds from default rose today to the highest in more than 14 months even amid speculation the Federal Reserve will unveil further measures to support the economy. At an annual symposium this time last year, Chairman Ben S. Bernanke hinted the Fed might embark on a second round of asset purchases, called quantitative easing, or QE2.
Flanagan, who heads Bank of America’s securitized-debt research, recommended in an Aug. 12 report that investors “overweight” government-backed mortgage debt and certain commercial-mortgage bonds, as well as fixed-rate prime-jumbo and so-called option adjustable-rate home-loan securities. That was in response to the Fed’s Aug. 9 pledge to hold its benchmark for short-term interest rates as low as zero until mid-2013.
Yields on most of those securities relative to benchmark rates widened last week as stocks extended losses to reach the biggest four-week decline in the Standard & Poor’s 500 Index since 2009, according to the Aug. 19 report.
Further negative economic data, including a 9 percent weekly fall in applications for loans to purchase homes, helped the analysts “turn more negative and see little reason to have anything but a market weight exposure to securitized products,” according to the Aug. 19 report by Flanagan and Jimmy Nguyen, who are based in New York. That’s “in spite of the attractive” valuations, they wrote.
Flanagan, who began this year overweight all categories of securities backed by loans and leases in part because of their falling supply, didn’t return a telephone message left today.
The “most obvious immediate candidate” for U.S. policy makers looking to stoke the economy would be a loosening of refinancing rules for loans backed by government-supported Fannie Mae and Freddie Mac, the analysts said. They recommended paring back on investments in interest-only, or IO, slices of mortgage bonds, which had been among their top recommended trades all year based on an expectation of limited refinancing.
So-called option-adjusted spreads, which take into account prepayment uncertainty, on some IOs now average about 4.3 percent, compared with 8.4 percent at the start of the year and as low as 2.9 percent in June, according to Bank of America Merrill Lynch’s Trust IO Agency CMO Index.
Buyers of government-backed mortgage securities “have been reducing risk amidst the recent turmoil” and “higher volatility will likely continue to weigh on investors’ risk appetite,” JPMorgan Chase & Co. analysts wrote in an Aug. 19 report.
Twenty-six percent of investors are now underweight the bonds, or holding less than found in benchmark indexes, compared with 9 percent in July, according to a survey by the analysts. Money managers are reducing their holdings, even as 92 percent of them agree with the New York-based company’s analysts led by Matt Jozoff that “a large-scale government-sponsored refi wave will be difficult to implement.”
A slump in prices for “distressed” floating-rate home- loan securities without government backing has been too small to “pique” interest in the debt among 60 percent of investors surveyed.
The bank’s non-agency mortgage-bond analysts led by John Sim recommended “legging” into securities such as those backed by subprime mortgages.
The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, increased 1.2 basis points to a mid-price of 123.9 basis points as of 1:14 p.m. in New York, according to Markit Group Ltd. That’s the highest since June 2010.
Projected yield spreads on so-called mezzanine commercial- mortgage bonds that were originally rated AAA rose 10 basis points last week to 595 basis points, or 130 basis points higher than July 1, according to the Bank of America report. Prime- jumbo home-loan securities climbed 5 basis points to 490 basis points, up by 65 basis points from July 1, according to the report. A basis point is 0.01 percentage point.
A Markit ABX index of credit-default swaps tied to subprime-mortgage bonds rated AAA when issued in 2006 fell last week to 47.4, less than 1 point from the 18-month low reached June 24 and down from as high as almost 55 in July, according to Markit. The index, whose levels signal that investors may pay similar amounts in cents on the dollar for comparable bonds, has fallen from a 30-month high of 62.7 in February.
Bank of America’s Flanagan said in a report the day that the index reached its recent low that it represented a “bottom for ABX prices as well as “risky assets” in general because home-price declines were set to slow.
Subprime-mortgage notes from 2005, 2006 and 2007 have lost 4.6 percent this month, Barclays Capital index data show. Commercial-mortgage bonds fell 1.7 percent on average and government-backed home-loan securities gained 1.57 percent, underperforming similar-duration Treasuries by 104 basis points.
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