Missing MBS in Bond Indexes Distort Funds, Citigroup Says

After years of using purchases of U.S. government-backed mortgage securities as a stimulus tool, the Federal Reserve owns almost a third of the debt outstanding.

One rarely discussed consequence: Money managers are being pushed to add more of the securities than they otherwise might because the benchmark debt indexes that they’re judged against fail to exclude the Fed’s sizable holdings, according to Citigroup Inc. analysts.

While the central bank’s $2.4 trillion of U.S. Treasury holdings aren’t found in most major broad measures of bond-market performance, that’s not the case for the $1.7 trillion portfolio of mortgage-backed securities that it’s built since 2009. The MBS allocation in Citigroup’s BIG index, for instance, would fall to 20 percent from 29 percent without those notes, according to a report by the analysts led by Ankur Mehta. Investment firms with specific mandates risk reporting abnormally poor performance in a slump when they stray too much from benchmarks.

“Given that money managers are gauged on how they perform versus fixed-income indices, the artificially higher allocation of MBS in the index forces money managers to buy the sector even if spreads are rich,” the New York-based analysts wrote in the Aug. 15 report.

MBS Spreads

The index dynamic, in turn, may mean lower returns for the “retail and institutional money” placed with managers who follow the gauges, they said.

Mortgage securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae ended last week offering 33 basis points more in yield than Treasuries, compared with 114 basis points for investment-grade U.S. corporate bonds and a 15-year average of 59 basis points, according to Bank of America Merrill Lynch index data. A basis point equals 0.01 percentage point.

Money managers would “currently be overweight MBS rather than underweight” if the indexes reflected the amount of bonds not held by the Fed, the analysts said. Pacific Investment Management Co.’s Total Return Fund, the world’s largest bond mutual fund, reduced its mortgage holdings to 20 percent in July from 22 percent the previous month. In April, the share fell to 19 percent, the lowest since 2010.

Even with the Fed tapering its monthly bond purchases on a pace that will end them in October, the Citigroup analysts say it’s time for index creators to reconsider their approach.

The criteria should be consistent, and the Fed’s home-loan holdings are even bigger than its 21 percent share of the Treasury market, they wrote. The amount of MBS in Citigroup’s index would fall to 25 percent if the Fed’s Treasury investments were included along with the mortgage debt.

Even after the central bank ends its buying, it’s expected to continue reinvestments meant to maintain the size of its balance sheet, they said.

Contrary to forecasts when the Fed began buying, the holdings “may be a long term phenomena,” the analysts said.

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