Mortgage Debt Least of Bad Bets as Investing Sinks

By Daniel Kruger

July 28 (Bloomberg) -- The fastest inflation in 17 years and a fourth straight quarter of U.S. profit declines are turning debt sold by Fannie Mae and Freddie Mac into the favorites of the world's biggest bond investors.

Pacific Investment Management Co., T. Rowe Price Group Inc., RiverSource Institutional Advisors and U.S. Bancorp's FAF Advisors, which oversee more than $1 trillion, say the government's decision to stand behind the beleaguered U.S. housing finance companies and their yields compared with Treasuries make the bonds a buy. The Senate approved legislation on July 26 allowing the U.S. to inject capital into Fannie and Freddie. President George W. Bush plans to sign it into law.

``We like it,'' said Bill Gross, who oversees the $128 billion Total Return Fund, the largest bond fund in the world, for Newport Beach, California-based Pimco. ``This legislation has indicated to investors that Fannie and Freddie are not implicitly guaranteed, not explicitly guaranteed, but we're close to that point.''

So far, 2008 has been a disaster for investors in the U.S. The fastest inflation since 1991 is diminishing returns of government debt, while the 256 companies in the Standard & Poor's 500 Index that reported earnings this quarter said profits fell an average 24 percent, hurting stocks and corporate bonds. Investors have accumulated $3.47 trillion in money market funds, just below the record set in April, according to the Money Fund Report newsletter.

Worst Since 1999

Corporate bonds, mortgage securities and Treasuries returned 0.5 percent on average in 2008, Merrill Lynch & Co. index data shows. This year is the worst for fixed-income investors since 1999, when they lost 1 percent. The securities gained 7.17 percent on average in 2007, including reinvested interest.

The bond market isn't providing investors with enough income to cover the rate of inflation, which rose 5 percent in the year ended June 30, Labor Department data show.

Treasuries returned 1.8 percent since December, after posting losses of 2.1 percent the three months ended June 30, the worst quarterly performance in four years. Corporate debt is down 0.2 percent, losing 0.7 percent last quarter, Merrill data show.

The S&P 500 fell 14 percent and the dollar declined 5.1 percent against the currencies of six trading partners as U.S. financial institutions posted loses and writedowns totaling $244 billion in the deepest housing recession since the Great Depression.

Dwindling Returns

Debt sold by Fannie Mae and Freddie Mac returned 1.63 percent this year, after losing 1.72 percent last quarter, according to Merrill Lynch index data. Bonds backed by the mortgages they own returned 0.73 percent this year following a loss of 0.66 percent in the three months ended June 30, a separate index shows.

The performance of U.S. assets ``is a reflection of the environment we're in today, which is a sluggish economy with some inflationary concerns,'' said Colin Lundgren, who is buying agency-backed mortgages as head of institutional fixed income for RiverSource in Minneapolis, which oversees $40 billion.

Economic growth may slow to 1.5 percent this year from 2.2 percent in 2007 as the benefits of $110 billion in tax rebates wear off and higher energy and food prices spur inflation to 4.1 percent, according to estimates of more than 60 forecasters surveyed by Bloomberg News.

Mortgage Bonds

Washington-based Fannie and Freddie of McLean, Virginia, buy mortgages from lenders and either hold them or package them as securities for sale to investors. They fund purchases by selling so-called agency debt. The companies also buy some of the securities they create from home loans, which investors refer to as agency mortgage bonds. The government-chartered companies account for almost half of the $12 trillion U.S. mortgage market.

Mortgage bonds created by Fannie and Freddie are attracting buyers because the debt yields about 1.56 percentage points more than Treasuries, according to Lehman Brothers Holdings Inc. data. The gap between the yields is approaching the widest point in two decades that was set in March, the data shows.

``The valuations should be attractive enough for traditional debt investors to make the shift'' to the securities, analysts at New York-based Lehman led by Vikas Shilpiekandula wrote in a report dated July 28.

The yield spread on fixed-rated mortgage securities sold by Fannie and Freddie widened 0.22 percentage point this month to near the March high of 1.71 percentage points, Lehman data show.

Losing Confidence

Investors lost confidence in the debt this year on concern Fannie and Freddie wouldn't have enough capital to cover losses. Foreclosure filings more than doubled in the second quarter from a year earlier as falling home prices left borrowers owing more on mortgages than their properties were worth.

The companies reported combined losses of more than $11 billion over the past three quarters and the total may climb to $48 billion by the end of next year, according to a July 18 report by JPMorgan Chase & Co. analyst Matthew Jozoff in New York.

S&P said on July 26 that it may downgrade the subordinated bonds of Fannie and Freddie. A cut would affect $19.2 billion of AA- rated debt, according to data compiled by Bloomberg. S&P affirmed the AAA ratings of the companies' senior debt.

S&P said the legislation authorizing a backstop of the mortgage-finance companies leaves it up to the Treasury to decide whether to honor preferred dividend payments or to repay subordinated bondholders before the government.

`Implicit Guarantee'

Fannie dropped 57 percent to $11.55 on the New York Stock Exchange since the start of June, while Freddie tumbled 67 percent to $8.27. A year ago, both were above $50.

Fannie, founded in 1938 as part of President Franklin Delano Roosevelt's New Deal, and Freddie, created in 1970, would cost U.S. taxpayers an estimated $25 billion over two years under Treasury Secretary Henry Paulson's plan if a bailout was necessary, the Congressional Budget Office said July 22.

White House spokesman Tony Fratto said Bush will sign the legislation into law, which will give the Treasury the right to buy unlimited stock in Fannie and Freddie and provide loans to the companies.

The companies ``are part of the solution in terms of the mortgage crisis,'' said Wan-Chong Kung, who manages $36 billion in fixed income at Minneapolis-based FAF Advisors, the asset- management arm of U.S. Bancorp. ``To the degree they are seen as having any problems it only strengthens their tie to the government in terms of their implicit guarantee.''

Extra Yield

The agency mortgage-backed securities market totals $4.6 trillion, about the same size as the Treasury market.

Five-year bonds sold by Fannie Mae yield 0.78 percentage point more than Treasuries of similar maturity, almost double the average over the past 10 years, according to data compiled by Bloomberg. That spread represents $78,000 in extra annual interest per $10 million of bonds.

The spread compares with a record low of 0.07 percentage point in May 2003, a month before Freddie disclosed accounting errors, and a high of 1.15 percentage points in March, just before the Federal Reserve agreed to finance JPMorgan Chase & Co.'s bailout of Bear Stearns Cos. Freddie debt also pays a spread of 0.78 percentage point.

Spreads provide a measure of sentiment, widening when bond investors are less confident that a borrower will repay its debt. Narrower spreads generally mean the opposite.

``They offer a lot of attractiveness,'' said Seth Plunkett, a fund manager at Mountain View, California-based American Century, which oversees about $20 billion in fixed income. ``Agency mortgages have the government guarantee. They are also backed by the mortgages underneath.''

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net