Mortgage-backed securities may lag in Fed pivot to Treasuries
Mortgage-backed securities may perform worse than government bonds in the coming months after the Federal Reserve said it plans to move more of its debt holdings into U.S. Treasuries.
The Fed said on March 20 that it plans to continue allowing the mortgage and agency bonds it bought as part of quantitative easing to run off, and to shift most of its portfolio into Treasuries over time. Starting in October, money it gets from principle and interest payments on its mortgage bonds will be reinvested into Treasuries, buying as much as $20 billion a month, the Fed said.
The new Fed plan may cut into some of 2019's excess returns in mortgage-backed securities. The Bloomberg Barclays US MBS Index has outperformed Treasuries by 0.53 percentage points this year.
In January, the Fed began signaling that it's less likely to boost rates in the future, igniting returns for fixed-income products broadly. Mortgages got a particular boost because with the Fed on hold, bond yields were expected to remain more stable, which helps the securities whose value depends in part on how predictable mortgage payments will be.
Even if the Fed plans to move more of its portfolio into Treasuries, there are factors that could boost mortgage bonds. With the Fed now on hold longer than previously expected, bond volatility should remain low. "Tactically, I like mortgages because the bid for liquidity will remain strong. Down in coupon may be the best trade due to the likelihood of the Fed staying strong with monetary accommodation and the lack of inflation," said Kevin Jackson, an analyst on Wells Fargo’s mortgage trading desk.
But there are also real risks for mortgage bonds that could hurt their performance. Home loan rates are tied to longer-term Treasury yields, so any decline in 10-year Treasury yields could pull mortgage rates down, and trigger more refinancing. Investors that paid more than 100 cents on the dollar for mortgage bonds could find themselves getting principal back sooner than they expected, cutting into returns. The average 30-year mortgage rate already dropped to 4.28% from 4.94% in November, according to Freddie Mac.
Homeowners whose mortgages are getting bundled into the current 30-year conventional mortgages, the premium-priced 4% and 4.5% securities, tend to have high credit scores and large loan sizes. It's relatively easy for them to refinance, sending investors in search of ways to reduce their risk. One way to do so is by purchasing "specified pools" — bonds created using borrower characteristics such as credit scores or loan size — designed to provide more certainty on when the underlying mortgages will be paid off.
"You need to add marginal forms of protection. Rates have been drifting lower since November and specified stories such as low- and medium-loan-balance pools are now very expensive with significant carry give. We favor others such as loan-to-value, modified pools and certain geographic exposure," according to Walt Schmidt, head of mortgage strategies at FTN Financial.
There was "one saving grace" for the mortgage sector in the Fed's balance sheet plan, Schmidt said. It is the announcement that any mortgage-backed security roll off above $20 billion per month will still be reinvested back into mortgages. "It's a back stop from the Fed in the event of a prepayment wave."