Mortgage Bonds in Worst Start Against Treasuries in 18 Years

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Government-backed U.S. mortgage bonds are off to their worst start to a year relative to Treasuries since at least 1997 as investors in the $5.5 trillion market brace for a surge in homeowner refinancing.

Returns on mortgage securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae were 0.6 percentage point less than those on similar-duration government debt this month through yesterday, according to Bank of America Merrill Lynch index data. Ginnie Mae securities, which package Federal Housing Administration loans, have underperformed Treasuries by 0.9 percentage point.

The relative slump, which continued today as 30-year Treasury yields fell to a record low, is being fueled by concern that refinancing is accelerating after home-loan rates fell to the lowest since May 2013. Investors in mortgage-backed securities are betting the trend will be further stoked by changes to government programs, including a lowering of insurance premiums on new FHA loans announced this month.

“After a year of low prepayment volatility, 2015 is bringing new risks to the MBS market,” Jeff Ryu, an analyst at Deutsche Bank AG, wrote today in a report.

The underperformance today included gains in prices of Fannie Mae’s 4.5 percent 30-year securities, for example, that lagged behind those on a basket of similar Treasuries by 0.2 cent on the dollar at 1 p.m. in New York, according to data compiled by Bloomberg.

Refinancing Wave

Agency, or government-backed, mortgage bonds have returned 0.45 percent this year, after gaining 6.1 percent in 2014, when they outperformed Treasuries by 0.74 percentage point, according to Bank of America Merrill Lynch index data. Investment-grade U.S. corporate bonds have returned 1.5 percent this year, trailing government debt by 0.4 percentage point. They lagged behind by Treasuries by 0.04 percentage point last year.

Applications for home-loan refinancings jumped 66 percent last week, the most since 2008, to the highest since July 2013, the Mortgage Bankers Association reported today.

Refinancing damages investors in mortgage bonds that trade for more than face value by returning their principal faster at par and curbing interest. Prices of government-backed mortgage securities average 106.5 cents on the dollar, meaning holders would lose 6.5 percent if they were immediately repaid.

FHA Fees

The annual fees the FHA charges to guarantee mortgages will be cut by 0.5 percentage point, to 0.85 percent of the loan balance, Julian Castro, secretary of Housing and Urban Development, said last week. The move also puts pressure on Fannie Mae and Freddie Mac to lower the fees they charge to guarantee mortgages with high loan-to-value ratios, according to Deutsche Bank.

W.J. Bradley Mortgage Capital has been getting busier even though the Centennial, Colorado-based lender hasn’t yet seen the FHA change creating a large amount of business, according to Chief Operating Officer Michael Kime.

While he’s “skeptical” the adjustment will do much to boost FHA loans for home purchases, “you’re going to see a lot of refinance activity,” Kime said. “You’re starting to see a lot of people ramp up marketing.”

Volumes in the mortgage-bond market are also surging, with the most common type of trading jumping about 50 percent from the start of last year, according to Trace data compiled by Empirasign Strategies.

One type of security for which investors have sought bids is debt known as Ginnie Mae inverse-interest-only tranches, or IIOs, which concentrate prepayment risk and carry coupons that float in the opposite direction of short-term rate benchmarks, other data from the firm show.

About a third of the $2.7 billion of those notes included in widely marketed auctions from the day of the FHA announcement through yesterday were described by dealers as failing to trade, showing potential disagreement among investors on the appropriate values, according to Empirasign data. Trade information wasn’t available for an additional 17 percent.

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