Fed-Watt Combo Deepens First MBS Loss Since ’94: Credit Markets

The first annual losses in U.S. government-backed mortgage bonds since 1994 are deepening as the dual threats of a new regulator and a Federal Reserve pullback leave buyers navigating around what JPMorgan Chase & Co. calls a modern-day Scylla and Charybdis.

The $5.4 trillion of securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae lost an average 0.7 percent in November, according to Bank of America Merrill Lynch index data. That’s the biggest drop since a 0.9 percent decline in June, when the debt was finishing its worst quarter in 19 years as concern grew the Fed would slow monthly bond purchases that include $40 billion of the notes.

A rule change paving the way for the White House to install U.S. Representative Mel Watt as overseer of Fannie Mae and Freddie Mac is spurring speculation he’ll expand a refinancing program that may reduce returns. That’s combining with potential losses from rising interest rates as the Fed considers scaling back the debt purchases, leading JPMorgan analysts to reference the mythical sea monsters represented by a rock shoal and whirlpool around which Odysseus must steer his ship in Homer’s epic poem.


“It’s very, very challenging at this point,” said Byron Boston, who headed Freddie Mac’s portfolio management group through 2003 and is now president and chief investment officer at Dynex Capital Inc., the Glen Allen, Virginia-based buyer of real-estate debt. “Government policy will drive returns, and how can I have an edge in predicting that? We’re in a high-risk environment and we’re adjusting our portfolio accordingly.”

The losses have been greatest on the types of low-coupon securities that guide home-loan rates, the target of the Fed’s purchases as it seeks to bolster the world’s biggest economy. The average rate on a typical 30-year fixed mortgage climbed to 4.29 percent last week from a record-low 3.31 percent a year ago, according to Freddie Mac data.

U.S. agency mortgage bonds, held by most bond funds, have lost 1.2 percent this year, trailing similar-duration government debt by 0.2 percentage point, Bank of America index data show. The securities last suffered an annual loss in 1994, dropping 1.6 percent during what Fortune magazine at the time declared a “bond market massacre” amid increases in the Fed’s target for short-term interest rates.

Lurking Dangers

With the threats to “rich valuations” headed into 2014, investors should enter the year “underweight,” or holding a smaller percentage of the debt than contained in benchmark bond indexes, Bank of America Corp. strategists including Satish Mansukhani and Chris Flanagan recommended last week in their 2014 outlook.

The lurking dangers to the market “argue for more defensive positioning, keeping some powder dry and bracing for a volatile year ahead,” the New York-based analysts wrote.

Investors are girding for Watt, a North Carolina Democrat who could be confirmed as soon as next week to run the Federal Housing Finance Agency, to expand the government’s Home Affordable Refinance Program for borrowers with little or no home equity. The “odds are high” that Watt will expand HARP by opening it to loans taken out after mid-2009, JPMorgan analysts led by Matt Jozoff in New York said in a Nov. 22 report.

Rule Change

Watt’s approval was eased after Senate Democrats voted last month to change the chamber’s rules to accept most presidential nominees with a simple majority. Senate Republicans, who approve of FHFA Acting Director Edward J. DeMarco’s policies, blocked the confirmation in October when all but two of them voted against moving his nomination to a final debate.

After the program was tweaked in late 2011, HARP facilitated refinancing of 721,813 mortgages in the first eight months of 2013 and 1.07 million last year, according to FHFA data. Since its inception in April 2009, the initiative has helped 2.89 million borrowers lower their payments.

Following the change in Senate confirmation rules, Fannie Mae’s 5 percent bonds fell, underperforming similar-duration Treasuries by about 0.5 cent on the dollar during the two days ended Nov. 22, the most this year, according to data compiled by Bloomberg.

“Some of the higher coupons have taken a hit given the expectation that he’ll extend HARP,” said Tom Sontag, a money manager in Chicago at Neuberger Berman Group LLC, which oversees about $227 billion in assets.

Prepayment Speeds

More refinancing can damage mortgage bonds trading for more than face value by returning principal more quickly at par while curbing interest. Fannie Mae’s 5 percent securities trade at almost 109 cents on the dollar, meaning investors would lose 9 percent if the underlying loans were all retired immediately.

Prepayment speeds for the mortgages, whose rates average about 5.48 percent, slowed last month to a pace that would erase 21.7 percent of the debt in a year, Bloomberg data show. That’s down from a six-month average of 30.9 percent as higher mortgage rates curb savings for borrowers and erode the ability of lenders to cover closing costs.

A HARP eligibility date change of one year could increase those speeds by 8 percentage points, according to the Bank of America analysts.

Policy clarity will take some time to emerge,” they wrote. “Until then, market attention will focus on risk exposures from aggressive policy measures, ranging from a HARP date extension” to the potential for borrowers to use the program multiple times, other streamlining of refinancing rules and principal forgiveness for troubled homeowners, they said.

JPMorgan Poll

Bond buyers have already “moved to the sidelines as Fed and policy uncertainty has risen,” according to the JPMorgan analysts. Of investors polled last month by the bank, 55 percent were “neutral” on agency mortgage securities, the greatest share since at least 2009.

About 27 percent who responded to the survey from Nov. 20 to Nov. 22 expected tapering of the central bank’s mortgage-bond acquisitions to begin in December or January. That was up from 13 percent in October, before the Labor Department released data showing American employers added 204,000 workers in October, topping the most optimistic forecast of economists.

Only 30 percent expected the slowing to start after March, down from 53 percent, the poll found. Minutes of the Federal Open Market Committee meeting Oct. 29-30 released Nov. 20 showed that Fed officials expected to reduce their purchases “in coming months” as the economy improves.

Fed Surprise

With the central bank’s surprise decision on Sept. 18 to maintain the pace of its bond purchases, mortgage debt in the Bank of America Merrill Lynch index gained 2.15 percent in September and October, the biggest two-month advance since the period ended August 2011.

As a decline in homeowner refinancing curbs creation of new securities, the central bank’s purchases will soon about match gross issuance, meaning “they almost need to taper the amount of mortgages they’re buying” in the next several months, Sontag said. “They run the risk of disrupting the market if they don’t.”

Elsewhere in credit markets, Microsoft Corp. plans to sell bonds in dollars and euros for the second time this year as the world’s largest software maker follows Johnson & Johnson by issuing AAA rated corporate securities this week. OAO Mechel, the Russian coal producer with about $9.55 billion in net debt as of June, won a waiver from a group of banks to delay payments on a $1 billion loan.

Credit Benchmarks

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, rose 0.6 basis point to 70.2 basis points as of 11:09 a.m. in New York, according to prices compiled by Bloomberg. The index, which has declined from a three-month high of 84.5 on Oct. 8, last week reached the least since Nov. 1, 2007.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings increased 2.6 to 80.6.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit 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.

Microsoft Offering

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased 0.16 basis point to 9.91 basis points. The gauge, which fell to a 20-year low of 8.5 on Nov. 26, typically widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate debt.

Microsoft is offering five-, 10- and 30-year notes in the U.S. currency, according to a person with knowledge of the offering who asked not to be identified because terms aren’t set. The Redmond, Washington-based company is also marketing 3.5 billion euros ($4.8 billion) of bonds split between eight- and 15-year portions.

Proceeds will fund general corporate purposes, Microsoft said today in separate regulatory filings. The euro sale would be the company’s biggest ever, more than six times the size of its debut issue of 550 million euros of 20-year notes that won a record-low 2.625 percent on April 25, Bloomberg data show. That sale coincided with almost $2 billion of dollar debt issued in three parts.

Mechel Waiver

Mechel’s loan payments amounting to about $600 million, which had been scheduled for this year and next, will be pushed to 2015 and 2016. Lenders including ING Bank NV, Societe Generale SA, UniCredit SpA and VTB Group agreed to the grace period, Mechel said in a statement. Last month, the company agreed with the banks on covenant holidays for the same loan.

Russia’s largest producer of coking coal for steelmakers, controlled by billionaire Igor Zyuzin, is among the country’s most indebted mining companies, with the ratio of net debt to earnings before interest, taxes, depreciation and amortization at about 10.9 times in the first quarter, ING said in a report last month.

The agreements take some pressure off the coal miner, which may need to buy back as much as 15 billion rubles ($451 million) of bonds in January and February under a put option, Bloomberg data show.

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