Mortgage Bond Rally May End, Rates Rise as Fed Stops Purchases

Dec. 31 (Bloomberg) -- Mortgage bonds are poised to slump after a record rally as the Federal Reserve’s unprecedented buying of $1.25 trillion of the securities ends as soon as March, driving up interest rates on new home loans.

Analysts at BNP Paribas SA, Credit Suisse Group AG and JPMorgan Chase & Co. say the extra yield over benchmark rates that investors demand to hold the securities will widen as much as half a percentage point as the Fed stops purchasing. The 11- month-old program has reduced yields, which guide lending rates, by about 1 percentage point, BNP estimates.

The Fed has been buying at “way” narrower spreads than “where the private sector would be willing to” invest, said Doug Dachille, chief executive officer of New York-based First Principles Capital Management LLC, which oversees about $8 billion of fixed-income investments.

Rising yields mean loan rates are likely to end 2010 almost 0.75 percentage point higher than they are currently, based on forecasts for government bonds and spreads, adding to challenges for a housing market struggling to recover from its worst slump since the 1930s. Fed Chairman Ben S. Bernanke’s goal this year has been to lower the costs for consumers to borrow and help bolster the economy as banks curbed lending.

Excess Returns

So-called agency mortgage bonds guaranteed by companies such as Fannie Mae and Freddie Mac returned 4.8 percentage points more than Treasuries this year, their best performance in at least 20 years, according to Barclays Capital index data. Last year, the debt returned 2.15 percentage points less than government notes.

The Fed began purchases in the $5.4 trillion market of securities guaranteed by government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae in January, acquiring a net $1.1 trillion so far.

Yields on Washington-based Fannie Mae’s current-coupon 30- year fixed-rate mortgage bonds were 4.53 percent yesterday, below the average of 5.59 percent in the five years through 2008, according to data compiled by Bloomberg.

The bonds yield 0.74 percentage point more than 10-year Treasuries, compared with the average of 1.27 percentage point over the past five years, and as high as 2.38 percentage points in March 2008. The spread was 0.68 percentage point on Nov. 24, the narrowest since 1992.

Bank Demand

Banks will probably buy more of the securities as that gap widens, limiting increases, according to John Anzalone, head of research and trading for mortgage bonds at the institutional unit of Atlanta-based asset manager Invesco Ltd.

“Banks are buying Treasuries right now, so you’ve got to figure at some point” mortgage bonds will be in demand, said Anzalone, whose firm oversees $414 billion in assets. “The question is just how far” spreads need to widen, he said.

Commercial banks’ holdings of Treasury and agency debt excluding mortgage securities rose $93.9 billion since June 30 to $424.7 billion, while their investments in agency mortgage bonds expanded $16.3 billion to $1 trillion, Fed data show.

Mortgage-bond yields help determine what lenders must charge consumers on home loans to make a profit when selling the debt, which in turn provides cash for new lending. Yields on the agency mortgage bonds are guiding rates on almost all new U.S. home lending following the collapse of the non-agency market in 2007 and a retreat by banks.

Falling Rates

The rally in the bond market has helped pushed the average rate on a typical 30-year fixed mortgage to a record low of 4.71 percent in the week ended Dec. 11, according to McLean, Virginia-based Freddie Mac. While the rate has since risen to 5.05 percent, it’s below the average of 6.05 percent last year and as high as 8.64 percent in May 2000.

Signs that housing may have bottomed are emerging. Sales of existing homes jumped 7.4 percent to a 6.54 million annual rate in November, the highest since February 2007, the National Association of Realtors said Dec. 22 in Washington. The S&P/Case-Shiller index of home prices in 20 U.S. cities rose 0.4 percent in October from September, the fifth consecutive gain.

Obstacles to a recovery include 10 percent unemployment; expiring tax credits for buyers; as many as 10 million looming foreclosures; and a plan to tighten standards at the Federal Housing Administration, the U.S. mortgage-insurance agency involved in about a third of loans for home purchases, according to analysts including Merrill Ross at BGB Securities Inc. Arlington, Virginia, and Laurie Goodman of Amherst Securities Group in New York.

Housing Doubts

The Fed may decide to continue purchasing mortgage bonds if the rebound in the property market proves short-lived, Invesco’s Anzalone said. Bernanke said in Dec. 3 testimony to Congress that officials “will have to see how the economy is evolving and whether or not we need to do more.”

While the S&P/Case-Shiller index shows home values are rising after a record 33 percent drop from 2006, Pacific Investment Management Co. mortgage-bond head Scott Simon said such data is misleading because of a temporary curb on home seizures tied to government anti-foreclosure efforts that will reverse next year.

Newport Beach, California-based Pimco’s Total Return Fund, the world’s biggest bond fund, cut holdings of mortgage securities as the Fed bought, to 12 percent in October, the lowest since at least 2000, from 62 percent on Dec. 31, according to the firm’s Web site. Government debt rose to 63 percent in September, the most in five years, before falling to 51 percent.

Treasury Purchases

The central bank stopped buying Treasuries in the last week of October. Since then, the yield on the benchmark 10-year note has risen to 3.79 percent from 3.50 percent. It will rise to 3.97 percent by the end of next year, according to the median estimate of 60 economists and strategists surveyed by Bloomberg.

It’s unlikely the Fed’s exit will create “dramatically” higher mortgage rates, said William Cunningham, global head of credit strategies and fixed-income research at the investment unit of Boston-based State Street Corp., the world’s largest money manager for institutions.

Cunningham cited tighter mortgage-bond spreads after the Fed’s purchases slowed in October. Issuance fell at the same time as a result of lower refinancing and home buying, meaning the Fed reduction “really hasn’t had the detrimental impact a lot of people were anticipating,” he said.

Supply Outlook

Limited supply is likely to help the market next year too, he said. Issuance of agency mortgage bonds may fall 20 percent in 2010, according to New York-based Citigroup Inc.

“The disruption, relative to the swings we’ve seen over the past year, should remain relatively muted,” said Roger Bayston, a senior vice president in San Mateo, California-based Franklin Templeton Investment’s fixed-income group, which oversees more than $200 billion of bonds. “I don’t think anybody wants to see higher mortgage rates, given the fragility of the housing market and broader economy at this time.”

All parts of the credit market may suffer if Bernanke retreats, after tight spreads on mortgage securities pushed bond buyers into debt such as low-rated company bonds and mortgage securities without government backing, according to JPMorgan.

“We can see the Fed’s footprints indirectly in many other markets as healing has spread,” Matt Jozoff, a New York-based mortgage-bond analyst at JPMorgan, wrote in an outlook report for 2010.

The mortgage-bond market also may face challenges from policies at Fannie Mae and Freddie Mac, even after the Treasury on Dec. 24 gave them more time to shrink their own holdings of the bonds. They are set to begin buying defaulted and modified mortgages from the securities they guarantee at a faster pace, according to Credit Suisse. That may hurt bonds with relatively high coupons, which Pimco’s Simon said are most overvalued.