Zero-Rate Calm Belied by Demand for 15-Year Mortgage DebtJody Shenn
For evidence that U.S. bond investors aren’t being satisfied by Federal Reserve Chair Janet Yellen’s dovish words, take a look at government-backed mortgage securities.
In a market dominated by 30-year loans, buyers from banks to real estate investment trusts have piled into debt tied to 15-year mortgages offering greater protection against rising interest rates. More demand for the shorter-term debt caused yields in the securities to evaporate, with one measure of spreads over Treasuries narrowing to just 0.02 percentage point last month from more than 0.4 about a year ago.
While bond bears were pushed to capitulate across fixed-income markets as yields defied forecasts and declined this year, some investors are still looking for safety. For those willing to sacrifice returns, 15-year securities offer banks and REITs in the $5.4 trillion mortgage-bond market a way to hedge some of their risks while sticking with the debt, according to Brean Capital LLC’s Scott Buchta.
“It’s one of those things where these guys are investing defensively,” said Buchta, the head of fixed-income strategy at the New York-based brokerage. “You’re not trying to kill it, you’re trying not to be killed if things go the other way.”
Yellen reiterated to lawmakers yesterday that “a high degree of monetary policy accommodation remains appropriate” to combat persistent weakness in the nation’s economy. The central bank’s target for short-term rates -- held at almost zero since December 2008 -- is likely to stay low for a “considerable period” after the Fed ends its unprecedented bond purchases as soon as October. The U.S. Treasury 10-year yield rose 0.01 percentage point to 2.56 percent at 8:52 a.m. in New York, according to Bloomberg Bond Trader data.
Shorter maturities on 15-year mortgage bonds and faster repayment of principal than 30-year debt mean they’ll slump less if long-term yields climb. There’s also less risk that the notes remain outstanding longer than investors anticipate if higher borrowing costs curb refinancings and home sales.
Even as bond managers have taken on more risk as 2014 progressed, they’re still looking to shield against rising yields that can lead to losses on fixed-income securities.
In January, the duration of their holdings, a measure of risk that is partly tied to the length of maturities, fell the most below their stated targets in years, according to surveys by Stone & McCarthy Research Associates. While not as bearish, fund managers were still positioned below their targets in the Princeton, New Jersey-based research firm’s July 8 poll.
While 15-year mortgage securities look too expensive to most investors, the rate protection is more important to certain types of buyers, said Jason Callan, Columbia Management Investment Advisers LLC’s structured-products head.
“There’s been significant demand from the REITs, so it makes sense why valuations are where they are,” said Callan, who oversees about $17 billion in mortgage-related assets from Minneapolis.
Banks are being lured to the shorter debt in part because tougher capital rules have left them with even more incentive to avoid paper losses on bond holdings, Buchta said. With increasing deposits and limited loan growth, commercial banks still boosted their agency mortgage-bond holdings by about $35 billion in the first half of this year to $1.35 trillion, Fed data show.
REITs that invest in mortgages shifted more into safer 15-year debt after their shares were rocked last year by the debt slump that followed the Fed’s signals it was approaching the start of a tapering of its then-$85 billion in monthly bond buying. They lost 20.7 percent in the four months ended August 2013, assuming reinvested dividends, a Bloomberg index shows. They’ve since gained almost 22 percent as bond appreciated.
At American Capital Agency Corp., the second-largest mortgage REIT, 15-year securities jumped to 48 percent, or $34 billion, of its investments as of March 31, according to company presentations. That’s up from 22 percent, or $22.6 billion, a year earlier.
The increase mainly occurred in the second quarter of last year, with the Bethesda, Maryland-based firm reducing the holdings this year, President Gary Kain said in an e-mail. “Many people seem to attribute the strength of 15s to us despite the fact we were net sellers,” he wrote, saying he couldn’t comment further before his company’s quarterly earnings.
Kain said during a presentation last month that he still believed yields will rise and spreads will widen over time. The shorter securities offer good protection against that with principal that comes back more quickly, he said.
The safety is coming with a cost. Thirty-year mortgage securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae have gained 3.9 percent this year after losing 1.6 percent on average last year, according to Bank of America Merrill Lynch index data. Fifteen-year debt, which fell just 0.92 percent in 2013, has underperformed this year with a 2.5 percent gain.
For 30-year securities, a measure of relative yields known as option-adjusted spreads, which takes into account expected rate volatility, narrowed to 0.29 percentage point, from 0.6 percentage point a year ago, the data show. Fifteen-year bond spreads fell to 0.02 percentage point on June 23 before widening to 0.11 percentage point.
Not all mortgage REITs piled into 15-year securities. The debt accounted for just 11.4 percent of Annaly Capital Management Inc.’s $65.3 billion in fixed-rate agency mortgage holdings on March 31, according to a company presentation.
“The valuations are on the extreme side,” David Finkelstein, head of agency mortgage trading at New York-based Annaly, the largest mortgage REIT, said last month in a telephone interview.
Fifteen-year mortgages have become rarer because they are typically used more during periods of high refinancing, as borrowers seek to shorten or maintain the length of their debt.
As higher rates reduced refinancing, issuance of 15-year Fannie Mae and Freddie Mac bonds fell 69 percent to $43.5 billion in the first half of 2014 from a year earlier, compared with a 56 percent drop to $183.6 billion for 30-year securities, according to Bank of America data. The amount of conventional 15-year debt outstanding dropped $15.5 billion, while the 30-year market grew $12.3 billion.
The shrinking of the 15-year market will help to support the debt, Satish Mansukhani, an analyst at the bank, has written in reports this year. Nomura Holdings Inc. analysts led by Ohmsatya Ravi recommended bets this month that 30-year debt would outperform 15-year securities.
Banks and other investors, which have also turned to slices of debt known as collateralized mortgage obligations for protection, should start favoring rarer and higher-yielding 20-year securities over 15-year bonds, said Walt Schmidt, a Chicago-based strategist at FTN Financial.
“We’re more in the camp that things aren’t going to move so soon,” he said in a telephone interview. For those concerned that long-term rates are set to spike, “the 15-year market is probably a good place to be.”
(An earlier version of this story corrected the spelling of Mansukhani’s name in the 22nd paragraph.)