TCW to Loomis Selling Agency Debt Ahead of Fed MovesAlexis Leondis
Days after TCW Group Inc.’s Mitch Flack saw Treasury yields plunging on Oct. 15, he was selling some of his mortgage bonds. Thanks to the Federal Reserve, he plans to keep shifting his mortgage holdings this year.
On that October day, a lack of sellers helped spur Treasury yield fluctuations. Flack said he expects increased volatility for mortgage-backed securities in 2015 as investors anticipate the first interest-rate rise from the Fed since 2006.
“The slow sea change out of the Fed gives us some significant cause for concern,” said Flack, 54, who’s co-head of securitized products at TCW and works on the $52 billion Metropolitan West Total Return Bond Fund in Los Angeles.
After mortgage-backed securities backed by the government delivered their best performance last year since 2011, some managers are reducing their agency holdings and warning of a bumpy 2015. Higher rates will ultimately mean lower prices for the securities.
The securities returned 6.1 percent in 2014, aided by the Fed’s bond buying and low supply of new mortgages, according to data compiled by Bloomberg. The Fed holds about $1.7 trillion of MBS after its purchase of the debt since 2009.
As the Fed exits its unprecedented stimulus program and prepares to raise interest rates, there could be communication stumbles that will spur volatility for agency mortgages, said Jay Schwister, who helps run the $6.7 billion Baird Core Plus Bond Fund in Milwaukee. Investors will be trying to anticipate the pace of Fed rate hikes, such as whether they will come at regular intervals, he said.
Investors also will have to grapple with less liquidity in the bond market. Regulations require banks to hold more capital for bonds and they have reduced the size of their balance sheets, Flack said.
The Metropolitan West fund attracted $9.9 billion in October and November, the most among intermediate-term bond funds, according to estimates from research firm Morningstar Inc. Bill Gross’s departure from Pacific Investment Management Co. in September spurred the exodus of investors into rival funds.
The MetWest fund returned almost 6 percent annually for the past three years, putting it ahead of 95 percent of peers, according to data compiled by Bloomberg. It now has a lower allocation to MBS backed by the government than its index, the Barclays U.S. Aggregate Index. Flack had been gradually selling mortgage bonds before Oct. 15, and continued shifting afterward.
“From 2008 to 2012 was just a free gift from the Fed -- you could hold agency securities and you made money,” said Anup Agarwal, head of mortgage and asset-backed securities at Western Asset Management Co. in Pasadena, California. “Now you have to be more selective with agency.”
Agarwal is less wary of the agency market than other investors and is keeping his MBS holdings. While the Fed has stopped adding to its MBS investments, it’s still reinvesting to maintain the size of its holdings. Since the net supply of new mortgages will likely grow slowly next year, MBS will continue to perform fairly well in 2015 despite the bumpiness, Agarwal said.
The agency mortgage-bond market will expand by $75 billion in 2015 -- a fraction of 2013’s pace -- as the housing market shows “some improvement,” according to Citigroup Inc. analysts led by Ankur Mehta.
Mortgage-backed securities will suffer when the central bank raises rates. The prices will drop along with most fixed-income securities. MBS investors will get a “double whammy” because the duration of the securities also will be extended, accentuating their price declines and delaying their investment returns, said Warren Pierson, a portfolio manager on the Baird fund.
The fund, which attracted more than $2 billion from investors in October and November, has been focusing on commercial mortgage-backed securities and investment grade corporate debt instead of agency mortgages this year, Pierson said.
The $4.3 billion Loomis Sayles Core Plus Bond Fund started reducing its exposure to agency MBS last month. With a stronger economy and rising home values, the risk of borrowers making mortgage prepayments by refinancing or selling increases, said Chris Harms, co-head of the relative return group at Loomis Sayles & Co.
To hedge that risk, the fund is buying bonds backed by multi-family properties that can’t be prepaid for set periods of time, and reverse mortgages. The prepayment risk could be short-lived as interest rates climb higher, since fewer people prepay their mortgages when these costs rise, he said.
“We like securities that regardless of rates are priced correctly for as many outcomes as there can be,” said Harms. The Loomis fund has returned 5.7 percent over the past three years, ahead of 93 percent of rivals.
Some money managers are also finding alternatives to non-agency MBS. Subprime mortgage debt has rallied, with an 80 percent return since 2010 and a 15 percent gain last year, according to Barclays Plc index data. As prices have risen and supply dwindles, the opportunities are more limited, said Western’s Agarwal.
“There’s no doubt about it, no comparison, if you’re searching for yield, there are better options than legacy non-agency RMBS,” Agarwal said.
Agarwal said he’s adding commercial real estate in Europe and private student loans to Western funds, including the $12.9 billion Western Asset Core Plus Bond Fund, another beneficiary of redemptions at Pimco. The Western Asset fund returned 7.7 percent over the past 12 months, ahead of 95 percent of peers, Bloomberg data show.
Flack said he’s buying commercial MBS, where underlying properties had the fastest rebound in market prices from their depths in 2008. He’s sticking with top-rated securities issued in 2011 and 2012 when underwriting standards were tighter than they are now to minimize risk.
“There’s going to be some volatility at some point in these mortgage markets,” Flack said. “So we’re just trying to prepare for all of it.”