After posting their worst returns since 1999, US government-backed mortgage bonds are starting 2013 with losses on speculation that the end of Federal Reserve purchases is in sight and as homeowner refinancing roils the market.
The slump spans from new low-coupon securities the US central bank is targeting to bonds backed by higher-rate loans more damaged by refinancing, the biggest portion of the $5.3 trillion market. A Bank of America Merrill Lynch index has lost 0.2 per cent this month after returning 2.6 per cent in 2012.
“The start of the year has been weak across the board,” said Mahesh Swaminathan, the head of residential mortgage-bond strategy at Credit Suisse Group AG in New York, in a telephone interview.
The declines show the risks to investors from the Fed’s effort to hold borrowing costs at record lows by adding $40 billion a month of mortgage debt to its balance sheet, as well as from President Barack Obama’s bid to help more homeowners lower their bills. Prepayments on Fannie Mae, Freddie Mac and Ginnie Mae bonds trading for more than face value, damage holders by returning their principal faster at par and curbing interest.
Minutes of a December meeting of Fed policy makers released January 3 showed their debt-buying program may end this year. That’s depressing the values of low-coupon agency mortgage securities that became inflated by the purchases.
Fannie Mae
High-coupon securities fell on Bank of America Corp.’s plan announced January 7 to sell contracts to service almost $200 billion of loans. Investors speculated the move added to the risks of more refinancing through the federal Home Affordable Refinance Program, or HARP, which helped boost replacement loans by 34 per cent to $1.75 trillion in 2012, Mortgage Bankers Association estimates show.
Fannie Mae’s 3.5 per cent securities fell last week to 106.1 cents from 106.6 cents on the dollar at year-end, according to data compiled by Bloomberg. The debt finished 2011 at less than 103 cents. The guarantor’s 5.5 per cent securities declined to 108.5 cents from 108.6 cents on December 31.
Elsewhere in credit markets, the extra yield investors demand to hold corporate bonds globally rather than government debentures fell to the lowest level in more than two years. The cost of protecting company debt from default in the US rose. Issuance soared.
Default swaps
Relative yields on company bonds from the US to Europe and Asia contracted 3 basis points to 142 basis points, or 1.42 percentage points, the least since April 2010, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields fell to 2.60 per cent from 2.64 per cent on January 4.
The Barclays Capital Global Aggregate Corporate Index has gained 0.08 per cent in January, bringing the 12-month gain to 11.52 per cent.
The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, added 1.6 basis points to a mid-price of 87.2 basis points, according to prices compiled by Bloomberg. The measure touched 84.9 on January 7, the lowest since September 14.
The Markit iTraxx Europe Index of 125 companies with investment-grade ratings decreased 1.5 to 100.5 at 9:54 am in London. In the Asia-Pacific region, the Markit iTraxx Australia index rose 0.5 to 113.5.
The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.
Sales soar
Bonds of Bank of America were the most active dollar-denominated corporate securities last week, accounting for 6.6 per cent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
A $6 billion, three-part offering from the Charlotte, North Carolina-based lender led $131.7 billion of bonds sales worldwide last week, Bloomberg data show. Issuance compares with $27.9 billion in the period ended January 4 and a weekly 2012 average of $76 billion.
A $3 billion portion of 3.3 per cent, 10-year notes rose 0.7 cent from the January 8 issue price to 100.1 cents on the dollar to yield 3.287 per cent, Trace data show.
In emerging markets, relative yields widened 18 basis points to 265 basis points, according to JPMorgan Chase & Co.’s EMBI Global index. The benchmark has expanded from 245 on January 3, the tightest since April 2010.
Pimco outperforms
Average returns on US agency home loan bonds in 2012 were the least since a 1.6 per cent gain in 1999, according to the Bank of America Merrill Lynch U.S. Mortgage-Backed Securities index. The measure returned 6.14 per cent in 2011.
Pacific Investment Management Co was among investors that outperformed the index by acquiring the same types of securities that the Fed started accelerating purchases of in September. The central bank’s buying sent rates on new 30-year fixed mortgages to a record-low 3.31 per cent in November, according to Freddie Mac.
This month, that low-coupon debt is struggling. Losses accelerated after the minutes of the Fed’s December 11-12 meeting showed “several” members of the policy-setting Federal Open Market Committee said it would “probably be appropriate to slow or stop purchases well before the end of 2013.”
‘Relatively safe’
Bets on the low-coupon notes, while “relatively safe,” are “over in terms of capital appreciation” because their yields have fallen so low, Bill Gross, manager of the $285 billion Pimco Total Return Fund (PTTRX), the world’s biggest mutual fund, said in a January 4 interview on Bloomberg Television. The fund, which has been overweight mortgages, has returned 9.4 per cent in the past year to beat 93 per cent of competitors, Bloomberg-compiled data show.
Investors are overreacting to the Fed’s statement because the central bank is unlikely to end its purchases without sustained job growth and probably will slow the buying first, Credit Suisse’s Swaminathan said. The unemployment rate has held at or above 7.8 per cent in the last four months.
While the Bank of America transfers of servicing to Nationstar Mortgage Holdings Inc and Walter Investment (WAC) Management Corp will boost prepayments on high-rate mortgages, that risk is also being exaggerated, Swaminathan said. The loans will be moved gradually, and the transactions differ from shifts that caused surges in recent months, he said.
Loan prepayments
The servicing sale is important to higher-coupon securities because the lender oversees about 25 per cent of loans potentially eligible for the HARP initiative and has been “slow relative to their peers” to use the program, Barclays Plc analysts led by Nicholas Strand wrote in a January 7 note.
“Incorporating today’s development, HARP speeds are likely to remain sustained throughout 2013, if not higher,” they said.
Prepayment data released January 8 showed speeds for 30-year Fannie Mae loans rising 4 per cent last month to a pace that would erase 30.8 per cent of the debt in a year, conflicting with “expectations of flat to lower prepays,” according to Nomura Securities International. HARP-eligible loan speeds advanced to about the highest since the program began in 2009.
HARP helps borrowers granted Fannie Mae and Freddie Mac mortgages before mid-2009 tap lower rates even if they have no home equity. Obama pushed for a revamp of the program at the end of 2011, which was followed by further tweaks.
Varying incentives
The BofA sales probably won’t spur prepayment jumps as large as the spikes created by shifts in the past to so-called sub-servicers, outsourcers that don’t own long-term contracts, Swaminathan said. The buyers have “different economic incentives” because they would lose money as those contracts get erased along with profiting on originations, he said.
Speeds on loans sub-serviced by Walter Investment’s GreenTree unit remained at about an annualized 70 per cent in December after the company turned to Quicken Loans Inc to help refinance its borrowers, according to Nomura analysts.
Refinancing demand helped Quicken originate $70 billion of mortgages last year, up from $30 billion in 2011, as its workforce has climbed to about 8,900 from less than 5,400 a year ago, Chief Executive Officer Bill Emerson said.
The lender generally grew much more comfortable using HARP with loans it doesn’t service after changes in September that reduced the danger that appraisal errors could force it to later repurchase soured debt, he said.
“A big bunch of that risk has now been mitigated,” Emerson said in an interview at Bloomberg News headquarters in New York. “That was a line of demarcation for us to really get involved.”
Subprime debt
The reduced returns in the bond market last year as refinancing rose contrasts with how hedge funds that invest in mortgage debt beat all other categories. The $1.5 billion Metacapital Mortgage Opportunities fund topped Bloomberg Markets magazine’s rankings by rising 38 per cent through October, as the Pine River Fixed Income fund finished second at 33 per cent.
In 2011, Obama had said he wanted to boost homeowner refinancing and “if you did listen to that and took it seriously, you found good ways to take prepayment risk,” said Steve Kuhn, manager of $3.6 billion Pine River fund.
One was securities tied to borrowers with little or no home equity who refinanced under HARP already, and can’t use the program again, he said in a telephone interview.
The funds also benefited from non-agency bond gains that averaged about 21 per cent in 2012, according to Amherst Securities Group LP. Some subprime debt, which advanced more than 40 per cent, returned about 4.6 per cent through January 11, Barclays index data show.
