Oil Plunge Pause Improves Outlook for U.S. Home-Loan BondsJody Shenn
Bank of America Corp., which had been warning investors to avoid U.S. government-backed mortgage securities, reversed its call this week. The reason: oil prices are stabilizing.
The end of oil’s seven-month tumble probably signals that bond yields are poised to rise after they plunged too quickly, Bank of America analyst Satish Mansukhani said in an interview. Higher yields may push interest rates on new mortgages above 4 percent, making it less attractive for homeowners to refinance, and giving a boost to a $5.5 trillion debt market that in January suffered its worst monthly returns relative to Treasuries since 2008.
“Our calls have been entirely predicated on absolute yield levels,” Mansukhani said. A reversal in their drop “could bring mortgage rates back to a point where we’re above the key rate threshold” for borrowers to refinance.
Mortgage-backed securities are sensitive to swings in rates, often underperforming benchmark debt when they either rise or fall, because borrowing costs influence how fast homeowners refinance before their loans’ terms, typically 30 years, are over. When the securities pay off more quickly, returns can suffer, as occurred last month.
MBS guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae last month returned 0.95 percentage point less than similar-duration government debt, according to Bank of America index data. That was the biggest underperformance since November 2008, in the midst of the global financial crisis that began with surging mortgage defaults.
As oil fell to a seven-year low of $44.45 a barrel last month, helping shrink inflation expectations, 10-year Treasury yields dropped to 1.64 percent from 2.17 percent at the start of the year. Average rates on typical new 30-year mortgages dropped to 3.59 percent in the last week, the lowest since May 2013, according to Freddie Mac surveys.
With rates lower, refinancing applications from borrowers soared 84 percent in the last three weeks of January compared with the seasonally adjusted average last year, according to Mortgage Bankers Association data.
The activity also was fueled by a lowering of Federal Housing Administration insurance premiums, which President Barack Obama touted in his State of the Union address in January. The cost reduction caused analysts and investors to speculate that policy makers would take further steps to expand lending.
The regulator for Fannie Mae and Freddie Mac is also likely to reduce how much those companies charge to guarantee mortgages, hedge fund manager Deepak Narula of Metacapital Management wrote in a Jan. 28 letter to his investors. The change will likely be the equivalent of lowering mortgage rates by 0.10 percentage point to 0.15 percentage point, he said.
“The markets have already anticipated such a move and built in an additional concession for the uncertainty,” said Narula, whose flagship $1.2 billion mortgage-focused fund gained 11.4 percent in 2014, according to the letter.
Refinancing damages returns on mortgage bonds as more homeowners repay at par loans that are bundled within securities trading for more than face value. Interest payments to holders also stop. More lending can also boost issuance of new bonds for the market to absorb.
The mortgage securities returned 0.81 percent last month on an absolute basis, compared with a bigger rout in bonds known as interest-only tranches, or IOs. IOs, which are created out of simpler securities, concentrate the risks from homeowner prepayments.
One type of IO tied to Fannie Mae securities declined 19.1 percent last month. An investor in the notes using a basket of debt to hedge against rate changes lost 9.3 percent, according to Barclays Plc data.
Barclays analysts said in a report on Jan. 30 that they were moving closer to recommending bets on increases in yield premiums on mortgage bonds, which often rise as they underperform. But the Federal Reserve’s purchases of mortgage securities to maintain the size of a $1.7 trillion portfolio it has acquired to support the economy adds a tricky dynamic to the market, the analysts said.
The Fed bases the size of its monthly purchases on how much principal it has already gotten back after refinancings. That demand comes after lenders have already boosted supply with forward sales of securities in response to applications, which come weeks before loans close, the analysts led by Sandeep Bordia wrote. The “whipsaw” in the central bank’s buying relative to sales tied to new loans can add to supply-and-demand imbalances when rates either rise or fall.
Bank of America analysts on Dec. 16 told investors to “underweight” agency mortgage securities, or expect lower relative returns. They switched to an “overweight” on Feb 3 after oil prices began to rebound.
Oil rose to $51.40 a barrel as of 10:58 a.m. in New York, while 10-year Treasury yields climbed to 1.93 percent, after a report showing U.S. payrolls advanced 257,000 last month.
Credit Suisse Group AG analysts led by Mahesh Swaminathan wrote in a report Thursday that they also “see room” for mortgage bonds to outperform, based partly on an outlook for stabilizing interest rates. On Friday, the analysts ended one related recommendation, adopting a “neutral view,” after yield premiums narrowed.
So far this month, the debt is outperforming government bonds by more than 0.2 percentage point, Bank of America’s index data shows.
Some analysts are still advising caution with mortgage bonds. A slump in yields on bonds sold by other countries may continue, putting downward pressure on those on U.S. debt, according to Deutsche Bank AG analyst Steven Abrahams. Some of the worldwide trend may be tied to a new government in Greece.
“The showdown between Greece and the E.U. troika promises to keep feeding volatility in the rates market, and that raises the likelihood of sharply lower rates in all refuge markets, including the one for U.S. Treasury debt,” Abrahams wrote in a Feb. 4 report. “That’s a difficult environment for MBS.”
A jump in rates can also hurt mortgage-bond investors by extending the time they’re holding debt with low coupons when they’d rather be getting more cash to invest elsewhere. The debt’s second-worst relative performance since the 2008 crisis was in May 2013, when Treasury yields soared because of concern that the Fed would soon begin tapering its bond-buying program.
Gary Kain, who oversees about $71.5 billion of mortgage bonds as the president of American Capital Agency Corp., sees a need to balance the risks. His firm, the second largest real-estate investment trust that buys home-loan debt, has been purchasing more securities backed by 15-year loans for protection against changes in rates.
There’s not enough reason for investors to assume that rates have to stay this low, Kain said on a Feb. 3 conference call.
“On the other hand, it is also dangerous -- and I think this is something that other investors, a lot of people, did in 2014 -- to assume that rates couldn’t go lower or that we couldn’t stay here,” he said.
Bank of America’s commodities analysts expect oil prices to eventually go even lower than their nadir last month, which could further depress rates, according to Mansukhani, who described his team’s mortgage call as “tactical.”
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