Mortgage Bonds Rally as Fed Backstop Seen in QE3: Credit Markets

By Jody Shenn - Dec 14, 2011 3:00 AM GMT+0700

Relative yields on mortgage-backed securities that guide new loan rates fell to the lowest in five months as investors wager the Federal Reserve is on standby to expand its holdings if the U.S. economy or Europe’s sovereign debt crisis worsens.

Yields on Fannie Mae’s current-coupon, 30-year bonds ended last week at 94 basis points more than 10-year Treasuries, the narrowest since July 8, according to data compiled by Bloomberg. The spread widened to 105 basis points as of 2:53 p.m. in New York, after reaching 121 on Nov. 24.

The Fed is already bolstering the market, adding “dollar roll” trades this month that lower financing costs for investors, after starting in October to recycle proceeds from past investments in housing-related debt to help real estate escape its worst slump since the 1930s. While a smaller share of economists predict the central bank will add to its $1 trillion of holdings as the U.S. grows, bond buyers may benefit regardless, said Dwight Asset Management Co.’s Paul Norris.

“Let’s say that something bad happens in Europe,” said Norris, a senior money manager whose Burlington, Vermont-based firm oversees about $50 billion. “Initially mortgages may widen out a bit but what that would likely lead to is a really quick implementation of QE3,” he said, referring to what would be the third round of Fed asset purchases called quantitative easing.

If the situation is reversed and “Europe gets its act together,” benchmark interest rates would probably rise, benefiting mortgage-bonds spreads partly by reducing refinancing and the supply of new securities, Norris said.

Money managers are “overweight” on agency-mortgage bonds by the most in at least two years, JPMorgan Chase & Co. says.

Economists Forecast

While Federal Reserve Vice Chairman Janet Yellen, Governor Daniel Tarullo and Fed Bank of New York President William C. Dudley have signaled more mortgage-bond purchases are possible, economists say it’s growing less likely.

About 49 percent surveyed by Bloomberg News see the Fed announcing next year additional debt buying, down from more than two-thirds before the central bank’s November meeting. The Federal Open Market Committee said today the “economy has been expanding moderately,” at the conclusion of its meeting in Washington, and refrained from taking new actions to lower borrowing costs.

Elsewhere in credit markets, U.S. interest-rate swap spreads widened for a third day after a report that German Chancellor Angela Merkel is rejecting an increase in the upper limit of funding for Europe’s bailout mechanism. The cost to protect Morgan Stanley debt from losses tumbled after the bank reached a settlement with MBIA Inc. over credit-default swaps on commercial-mortgage bonds. Vivendi SA increased the interest margin on a planned 1 billion euro ($1.3 billion) credit line.

Credit Risk Measures

The difference between the two-year swap rate and the comparable-maturity Treasury note yield widened 2.46 basis points to 46.39 basis points as of 2:47 p.m. in New York, the most since Dec. 2.

The measure, which rises when investors favor government bonds, has expanded from 41.55 on Nov. 30, and gained as Reuters reported that Merkel has rejected raising the upper limit of funding for the European Stability Mechanism, the region’s permanent bailout fund.

The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, rose 0.7 basis point to a mid- price of 126.2, according to data provider CMA. The gauge has climbed from 79 on Feb. 8.

The Markit iTraxx Europe Index of 125 companies with investment-grade ratings dropped 1.5 to 184.25, according to JPMorgan at 11 a.m. in London.

MBIA Settlement

The indexes typically drop as investor confidence improves and rise as it deteriorates. 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 contract protecting $10 million of debt.

Contracts tied to Morgan Stanley debt fell 22.8 basis points to 402 as of 11:31 a.m. in New York, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

MBIA will make a $1.1 billion cash payment to Morgan Stanley as part of the settlement, according to a person familiar with the agreement who asked not to be named because the amount hasn’t been made public. Morgan Stanley will take a $1.2 billion loss this quarter related to the deal, the New York-based bank said today in a statement.

Vivendi Increases

Vivendi increased the interest margin to 85 basis points more than the euro interbank offered rate, according to two people with direct knowledge of the transaction. The Paris-based company agreed to lift the amount of interest and fees it pays after lenders rejected the 75 basis-point margin it initially proposed, the people said. The credit line will be for five years, with no extension options, the people said.

The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index fell 0.3 cent to 90.39 cents on the dollar, the lowest level since Nov. 29. The measure, which tracks the 100 largest dollar- denominated first-lien leveraged loans, has declined from 90.83 on Dec. 6.

Leveraged loans and high-yield bonds are rated below Baa3 by Moody’s and lower than BBB- by S&P.

In emerging markets, relative yields rose 3 basis points to 411, according to JPMorgan’s EMBI Global index. The measure has ranged this year from 259 on Jan. 5 to 496 on Oct. 4.

Anticipated Transactions

The Fed, which under QE1 bought $1.25 trillion of mortgage securities and $172 billion of other agency debt through March 2010, has purchased a net $56.1 billion since October to offset prepayments and maturities, Bloomberg data show. The acquisitions are focused on the $5.3 trillion market of home- loan bonds guaranteed by government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae.

Anticipation of more transactions may be boosting demand among private investors. About 64 percent of money managers surveyed by JPMorgan are “overweight” agency mortgage securities, or holding a greater percentage than found in benchmark indexes, the highest since at least mid-2009, according to a Dec. 9 report by the New York-based bank.

Because of the potential for QE3, government-backed mortgage securities “offer that rare beast: positive exposure to event risk,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, wrote in a Dec. 7 report. He recommended the bonds over other debt “within the interest rate sphere,” such as Treasuries, in his 2012 outlook.

Primary Dealer Forecast

Chairman Ben S. Bernanke and his fellow policy makers will start another QE program next quarter, 16 of the 21 primary dealers of U.S. government securities that trade with the central bank said in a Bloomberg News survey last month. The Fed may buy about $545 billion in home-loan debt, based on the median of the firms that provided estimates.

A majority of 51 percent of the 41 economists polled by Bloomberg from Dec. 7 through Dec. 9 said the central bank will refrain from QE3. That contrasts with a survey before the Fed’s November meeting that showed 69 percent forecasting the action. This month, 13 percent of the economists said they expect the move will be announced in January and 21 percent in March.

The likelihood has fallen after the unemployment rate declined to 8.6 percent from 9.1 percent, U.S. manufacturing expanded at the fastest pace in 5 months and vehicle sales climbed to their highest level in over 2 years.

‘Significant Downside Risks’

Today’s statement reiterated the warning at the Fed’s two previous meetings that “Strains in global financial markets continue to pose significant downside risks to the economic outlook.” Bernanke said last month that the sentence refers to the European debt crisis.

A program may include $700 billion of home-loan securities, Citigroup Inc. analysts said. That figure reflects how much would be needed to “tangibly influence” mortgage rates without disrupting functioning in the market, analysts Inger Daniels and Mayank Singhal wrote in the Dec. 9 report.

Tarullo, in an October speech, said additional mortgage- bond purchases should “move back up toward the top of the list of options” because “the aggregate-demand effect should be felt not just in new-home purchases, but also in the added purchasing power of existing homeowners who are able to refinance.”

Dollar Rolls

Yellen said in a Nov. 29 speech that she sees “see a strong case for additional policies to foster more-rapid recovery in the housing sector.” If the Fed opted to buy more bonds, “it might make sense” for much of those to consist of mortgage securities to boost the housing market, Dudley said Nov. 17.

During the week ended Dec. 7, the Fed engaged in $4.35 billion of paired purchases and sales of mortgage securities in different months for the first time since starting to reinvest in the market along with its “Operation Twist” for Treasuries.

Those so-called dollar rolls boosted mortgage bonds last week, JPMorgan analysts led by Matt Jozoff and Morgan Stanley analysts Vipul Jain, Janaki Rao and Zofia Koscielniak said. The implied cost of financing Fannie Mae 3.5 percent bonds, which had climbed in a few weeks from about 30 basis points to almost 50 basis points, retraced that advance, according to JPMorgan.

“Although funding markets in MBS have not shown significant signs of stress, financing rates have gone up in tandem with other funding rates, especially around year-end, and the Fed action helps alleviate some of those pressures,” the Morgan Stanley analysts wrote in a Dec. 9 report.

Financing Rates

With dollar rolls, an investor seeking to borrow money enters into contracts to sell mortgage securities in any month and then buy similar bonds the following month; a lender would undertake the opposite trades. Investors entering into transactions for other reasons may be on either side of the contracts.

The transactions will “facilitate the settlement of our outstanding MBS purchases,” Jonathan Freed, a New York Fed spokesman, said in a Dec. 6 e-mailed statement.

The Fed’s use of the trades underscored the central bank’s commitment to supporting the market, Dwight Asset’s Norris said. “All of their speeches that I’ve read and all of the anecdotal evidence points to them being fully involved,” he said.

While the central bank probably isn’t ready to announce additional mortgage-bond buying, it may provide new aid to the market if it details changes to its so-called communication strategy in a way that reduces expected interest-rate volatility, he added. Higher forecasted volatility damages investors by increasing doubt about when the debt will be repaid as projected homeowner refinancing fluctuates and by boosting hedging costs.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net