Government-backed U.S. mortgage bonds posted their worst monthly returns relative to Treasuries since the 2008 financial crisis as the $5.5 trillion market braces for a surge in homeowner refinancing.
Mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae, known as agency MBS, returned 0.81% last month, or 0.95 percentage point less than similar duration government debt, according to Bank of America Merrill Lynch index data. That was the biggest underperformance since November 2008, when other types of mortgage securities became the epicenter of turmoil that threatened the global financial system.
Such a relative slump depresses returns for investors such as mutual funds, real estate investment trusts and banks, while limiting the benefits falling bond yields offer home buyers. Returns on mortgage securities this year are held back by speculation that moves by policy makers to expand lending may add to a jump in refinancing. Pressure has been building as yields on 10-year Treasuries fell to lowest level since 2013, dragging down home-loan rates.
With yields tumbling, "the overall tone in the agency MBS market has turned decisively negative," Nomura Holdings Inc. analysts led by Ohmsatya Ravi wrote in a report.
Falling interest rates can damage returns on mortgage bonds, as more homeowners repay at par loans that are bundled within securities trading for more than face value. More lending can also boost issuance of new bonds, a negative for the market. A Jan. 30 report by Nomura cited the risks posed by increasing numbers of loans along with "policy uncertainty" after the announcement last month of a lowering of Federal Housing Administration insurance premiums.
A jump in rates can also hurt mortgage-bond investors, by extending the lives of debt with low coupons as refinancing and property sales slow. The debt's second-worst relative performance since the crisis was in May 2013, when its returns trailed those on government debt by 0.91 percentage point. That happened when Treasury yields soared because of concern that the Federal Reserve would soon begin tapering its bond-buying program.
Mortgage bonds known as interest-only tranches, or IOs, were among the worst performers in January. Such bonds concentrate the risks from homeowner prepayments. Yield premiums on one type soared to 6.4 percentage points from 3.4 percentage points on Dec. 31, according to Credit Suisse Group data.
Still, hedge funds with mortgage strategies that focus on IO bonds appeared to avoid suffering last month in the same way as they did during a "bloodbath" in the spring of 2013, said Troy Gayeski, a partner at New-York based SkyBridge Capital, which invests in hedge funds. They generally lost 0.5% to 1.5% in January, after typically returning 8% to 12% last year, he said.
"Towards the end of last year, as IO spreads tightened further and further, those guys really lightened up on that risk," with some also betting on wider spreads on simpler mortgage securities, Gayeski said. "It's ultimately really good news because it’s reset the opportunity again."
