Mortgages Slump Relative to Treasuries on Refinancing Risk

The U.S. mortgage-bond market is lagging behind the rally in government debt on concern that more homeowners will refinance at lower interest rates, damaging returns.

Fannie Mae’s 4.5 percent securities due in 30 years are underperforming a group of Treasuries with similar interest-rate risk today by the most since September 2011, according to data compiled by Bloomberg. Gains on the Fannie Mae notes trailed those on Treasuries by almost 0.6 cent on the dollar at 1 p.m. in New York.

Bond yields are falling as traders drop wagers that the Federal Reserve will raise interest rates next year amid global economic weakness. That increases refinancing risk for investors in mortgage bonds such as the Fannie Mae securities, which are trading at 108.4 cents on the dollar and would hand holders losses of 8.4 percent if immediately paid off.

“We’ve seen this show a number of times in the past: Treasuries move very far very fast, and agency MBS get left in the dust,” Ken Hackel, the head of securitized product strategy at CRT Capital Group LLC, wrote in a note to clients.

Treasuries surged today, with 10-year yields falling below 2 percent for the first time since 2013, as retail sales in the U.S. dropped more than forecast.

Prepayment Risk

The average rate on a typical 30-year mortgage fell last week to 4.2 percent, the lowest since June 2013, according to Mortgage Bankers Association data. The underlying loans in the Fannie Mae securities have interest rates of about 5 percent.

“The prepayment risk in the MBS market has increased and we recommend” betting against certain debt, Morgan Stanley analysts led by Vipul Jain wrote today in a note to clients, reiterating calls made Oct. 10.

The mortgage-bond market may be helping push interest rates on government debt lower because of a dynamic known as convexity hedging. As the projected lifespan of the underlying home loans shortens, some investors and loan servicers must buy securities that will continue to gain in a bond rally, helping offset their lost income streams.

Loan servicers probably needed to add the equivalent of about $25 billion of 10-year Treasuries in the U.S. government-bond and swaps markets, as well as about $30 billion of lower-coupon mortgage bonds, to rebalance their books, Nomura Securities International analysts led by Ohmsatya Ravi wrote in a note sent to clients this morning.

More Vulnerable

Refinancing applications already started climbing last week, rising 11 percent to the highest since June as borrowing costs dropped, the Mortgage Bankers Association said today.

Bonds tied to higher-rate loans are “especially at risk” and “more leveraged securities should get hit hard, as the beneficiary of slow prepays in recent quarters,” Hackel said.

Notes known as interest-only securities, often used by hedge funds and other investors to speculate on prepayment speeds, may be particularly vulnerable because their values are based on how long they remain outstanding given they return no principal when paid off.

The $5.4 trillion market for government-backed mortgage bonds has been supported by limited refinancing amid rates that had climbed from record lows. The market’s also been boosted by tighter credit and other trends that have made it tougher to get a mortgage.

The home-loan debt has beat Treasuries this year, gaining 5.3 percent through yesterday, or 0.5 percentage point more than U.S. government notes, according to Bank of America Merrill Lynch index data.

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