Fed Taper May Hurt Corporates More Than MBS, Morgan Stanley Says

Relative yields on U.S. corporate bonds may widen more than those on government-backed mortgage securities when the Federal Reserve tapers its debt buying, according to Morgan Stanley analysts.

Even as the central bank’s $85 billion of monthly Treasuries and mortgage-bond purchases give it an outsized presence in the market for home-loan securities, harder-to-trade company debentures may face more damage if a reduction in the asset buying triggers a steep drop in debt prices, the New York-based bank’s securitized products strategy team including Vishwanath Tirupattur and Vipul Jain said yesterday in a report.

“In a sharp-selloff scenario that leads to money-manager redemptions, lower liquidity in the corporate sector may turn out to be a bigger liability,” they wrote.

The Fed began adding $40 billion of mortgage securities a month to its balance sheet in September 2012 in the start of its third round of bond buying known as quantitative easing, or QE, intended to stimulate the economy. When including reinvestments in the market with proceeds from its holdings, the central bank is acquiring about 70 percent of mortgage-bond issuance, a share that’s growing as higher interest rates reduce new loans being used by homeowners to refinance, according to Morgan Stanley.

Liquidity Liability

While the analysts’ “base case” is that spreads on agency mortgage-backed securities will widen more as the Fed reduces debt purchases next year, lower liquidity in corporate notes may prove to be a bigger liability, they said.

The extra yield investors demand to own company notes instead of Treasuries fell yesterday to 0.93 percentage point more than spreads on agency mortgage bonds, Bank of America Merrill Lynch index data show. That’s down from as much as 2.37 percentage points in 2010.

With the gap about the least since the crisis, “any widening in the MBS market is likely to entice money managers from corporates back into mortgages,” the analysts said.

Morgan Stanley’s economists are predicting that the Fed will cut back on its mortgage-debt buying more slowly than its Treasury purchases, “which we don’t think is currently being fully reflected” in the mortgage-bond market, the analysts wrote in the report.

Spreads on mortgage securities widened to 0.47 percentage point yesterday from 0.25 percentage point at the end of 2012, while those for corporates narrowed to 1.4 percentage point from 1.54 percentage point, the Bank of America Merrill Lynch index data show.

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