Fed Neutralized in Mortgage Bonds on Supply Slump

The $5.4 trillion market for U.S. government-backed mortgage bonds is poised for its biggest first-half rally since 2010 as a surprising drop in supply outweighs a pullback in Federal Reserve purchases.

Following their first annual loss since Bill Clinton roamed the White House in 1994, the securities have rebounded to gain

3.7 percent this year, according to Bank of America Merrill Lynch index data. Yields on the most active debt fell last week to the lowest level relative to benchmark rates since January 2013, one measure shows.

The market has been able to withstand less demand from the Fed -- its biggest investor -- because issuance is slumping as home sales fail to keep up with 2013’s pace and property-buyers make purchases with just cash. The U.S. central bank said last week it will cut its monthly mortgage-purchase program by another $5 billion in July to $15 billion, down from $40 billion in December.

“There’s not a lot of bonds that have been created that need to be absorbed,” said David Finkelstein, head of agency, or government-backed, mortgage-bond trading at New York-based Annaly Capital Management Inc., the largest real-estate investment trust that buys debt. “There’s been real scarcity and, as a result, the Fed has had to take out bonds from existing holders.”

Sales Drop

The supply slowdown, whose size has confounded research teams and debt buyers alike, has essentially erased the Fed’s retreat as it pares its economic stimulus. The central bank’s fixed-rate mortgage-bond holdings have ballooned by almost $180 billion, far exceeding the market’s growth, or net issuance, of just $13 billion in the first five months of this year, according to data compiled by JPMorgan Chase & Co.

After totaling $280 billion last year, net issuance “has so far turned out to be a dud,” JPMorgan analysts led by Matt Jozoff and Brian Ye wrote in a June 13 report. They slashed their prediction this month for 2014 fixed-rate sales to $25 billion from $175 billion at the start of this year, in part because of a shift in consumer demand toward adjustable-rate mortgages and signs that banks are retaining more loans.

The JPMorgan analysts recommended at the beginning of the year that investors position themselves for relative yields that would stay the same, then moved in April to saying investors should bet on wider spreads after they tightened. They reverted to their neutral call on June 6 citing the “depressed supply.”

Forecasts Cut

Bank of America Corp. analysts led by Chris Flanagan and Satish Mansukhani cut their net-issuance forecast this month by 71 percent to $50 billion and Wells Fargo & Co.’s team led by Greg Reiter slashed theirs by more than half to a range of $40 billion to $80 billion in 2014.

The Fed began tapering its purchases after homeowner refinancings slumped because of rising interest rates, slowing gross issuance. As home sales slowed in the first quarter, all-cash purchases rose to 33 percent from 31 percent in 2013 and 29 percent in 2012, the National Association of Realtors said last month.

Jumbo mortgages too large to package into government-backed bonds also accounted for 18.7 percent of new loans in the first quarter, up from 11.4 percent a year earlier, according to newsletter Inside Mortgage Finance.

Reconsidering Views

The issuance slump has meant the central bank’s buying of fixed-rate mortgage bonds this year has comprised 68 percent of sales from December through May, according to Bank of America data that includes reinvestments. That share is up from 52 percent a year ago. In April, the Fed absorbed 83 percent of new bonds.

This year’s performance and sales drop has David Land, a bond manager at St. Paul, Minnesota-based Advantus Capital Management Inc., reconsidering his views on the longer-term.

“We felt that mortgages would do okay this year but we’ve been surprised by the strength,” said Land, whose firm oversees about $29 billion. “I was asking here today, ‘Do we need to rethink what the range of spreads should be in a market that’s not growing as fast as it used to?’”

Yields on Fannie Mae securities used to package new 30-year loans fell to within 108 basis points of an average of five- and 10-year Treasury rates on June 20, down from 122 basis points at year-end, according to data compiled by Bloomberg. That compares with an average of 144 basis points, or 1.44 percentage points, over the past decade.

Surprising Strength

Credit Suisse Group AG strategists led by Mahesh Swaminathan said May 1 that the supply-demand dynamic and stable bond yields forced them to “throw in the towel” on their suggestion to wager on wider spreads. In a report today, they reduced their net issuance forecast by 65 percent to $55 billion and gross issuance forecast by 12 percent to $870 billion.

The U.S. mortgage-bond market is also benefiting from a search for yield as the Fed maintains its benchmark rate near zero for the sixth year and the European Central Bank embarks on new stimulus measures.

Subprime-mortgage securities, among the more than $700 billion of non-agency bonds without U.S. government backing, gained almost 7 percent this year, according to Barclays Plc index data. That’s better than 5.7 percent return for high-yield U.S. corporate bonds, Bank of America index data show.

Interest-only securities, a type of notes created when agency mortgage bonds are repackaged into bonds with no principal, are also proving a hot bet. The securities are more sensitive to refinancings than traditional mortgage debt.

Fed Reinvestment

Relative yields on one type of IO have fallen to about 480 basis points from almost 700 basis points at the start of the year, according to Bank of America Merrill Lynch’s U.S. Agency CMO Trust IO index. A year ago, that spread was more than 1,300 basis points.

The mortgage market should be able to weather the end of the Fed’s mortgage buying without turmoil, according to Annaly’s Finkelstein.

Money managers are still holding a smaller share of the debt than found in benchmark indexes, spreads “look perfectly reasonable” compared to corporate bonds and banks have shown an appetite to add the notes when yields rise, he said.

If the Fed adopts a proposal to continue reinvesting maturing debt after it raises rates, that would also “be very supportive” of the market, Finkelstein said. Fed Chair Janet Yellen said last week in Washington that the central bank is considering how long to maintain its reinvestments.

While the end of the Fed’s quantitative-easing program may embolden investors to start selling mortgage bonds again, it may be too early to bet on carnage, according to Noah Estrin, a money manager at hedge fund Prologue Capital in Greenwich, Connecticut.

For now, “we’re taking a cautious approach,” he said. “A lot of market participants are.”