(Bloomberg News) A measure of relative yields on mortgage securities dropped to the lowest on record after the Federal Reserve said it will expand its purchases, extending a rally that offered hedge funds returns of 15 percent in a week.

A Bloomberg index of yields on Fannie Mae-guaranteed mortgage bonds trading closest to face value fell about 1 basis points to 92 basis points, or 0.92 percentage point, higher than an average of five- and 10-year Treasury rates as of 3 p.m. in New York. That's the narrowest spread since at least 1984 for the securities that guide U.S. home-loan rates.

"A typical fundamental-value framework really isn't applicable here" because the Fed's goals differ from those of normal investors, said Todd Abraham, co-head of the government and mortgage-backed fixed-income group at Federated Investors Inc. "It makes it pretty challenging to determine at what point you need to change your allocations. It's almost more of a case of needing to try to anticipate what others are going to do."

The Fed's focus on the mortgage market, after speculation its third round of so-called quantitative easing would also include U.S. government bonds, capped a rise today in the housing debt's absolute yields. A climb of 9 basis points from a record low to 2.21 percent reflected a jump in benchmark Treasury yields as the central bank's move yesterday to strengthen the economy created soaring inflation expectations.

The spread, which tumbled 20 basis points yesterday as the central bank announced a plan to expand its holdings with monthly purchases of $40 billion of agency mortgage bonds, has declined from 152 at the start of the year.

Spread Measures

A type of bet on the outperformance of mortgage bonds that was recommended on Sept. 6 by Credit Suisse Group AG offered a gain of 1.5 cents on the dollar through late yesterday, when analysts led by Mahesh Swaminathan said in a note it was no longer attractive. With the 10-times leverage often employed by hedge funds on such wagers, potential returns were 15 percent.

Relative yields may not widen even with so-called option- adjusted spread measures signaling the bonds offer less yield than Treasuries, Nomura Securities International analysts led by Ohmsatya Ravi said.

With much further spread tightening amid the start of the Fed's purchases today, "investors should consider exiting overweights," they wrote. Still, "investors shouldn't consider shorting agency MBS yet, considering that the likely size" of the open-ended program "is not known at this time."

$1 Trillion

A "reasonable person" could see additions of as much as $1 trillion to the Fed's holdings in the $5.2 trillion market for agency, or government-backed, mortgage securities, according to the Nomura analysts, the second-ranked for strategy on the debt in this year's Institutional Investor magazine poll. An increase of $650 billion is most likely, they said. The central bank already owns about $850 billion.

Investors are usually considered overweight if they are holding more of the debt than found in benchmark indexes.

About 77 percent of investors surveyed by mortgage-bond analysts at JPMorgan Chase & Co. last week expected the Fed would start a round of bond buying involving home-loan securities. Among the respondents, 22 percent predicted it would be announced at yesterday's meeting and 26 percent in October.

Most expected $200 billion to $500 billion of mortgage-bond purchases. Seventy percent said they were already overweight the securities among those guaranteed by government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae that the central bank would target.

'Incredible' Performance

"Many were expecting they would do something, but the probability seemed pretty low they would do something open-ended like this," Federated's Abraham, whose Pittsburgh-based firm manages about $356 billion of assets, said in a telephone interview. "You're seeing performance that's frankly pretty incredible."

Bond gains amid Europe's debt crisis, concern that the U.S. economy is slowing and anticipation of Fed purchases drove down the average rate on a typical 30-year mortgage to a record low 3.49 percent in the week ended July 26, according to Freddie Mac data. After a subsequent increase to as high as 3.66 percent, borrowing costs declined through the week ended yesterday, falling back to 3.55 percent.

Swings in lending rates have been smaller than seen in bond yields as lenders prevent borrowing costs from falling too far to avoid being overwhelmed by applications a jump in refinancing demand. That dynamic will limit the initial declines in mortgage rates from falling yields on home-loan securities after the Fed announcement, according to Credit Suisse.

Including an existing program in which the Fed is reinvesting proceeds from its past purchase of housing debt into the market, the central bank will be buying about $65 billion to $70 billion a month, Bank of America Corp. analysts including Chris Flanagan and Satish Mansukhani said in a report yesterday.

Cheap Financing

"As it stands right now, this volume of purchases would absorb a substantial share" of issuance, which totaled $122 billion in August, they wrote.

The securities that the Fed may target "could remain rich and tighten further based on the strong technical backdrop this creates, the outlook for lower volatility" and potential for especially cheap financing costs to be created for investors using the so-called dollar roll market, they said.

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.

Higher Volatility

Higher forecasted rate volatility increases doubt about when mortgages will be repaid because homeowner refinancing fluctuates, as well as the cost of options used as hedges. Investors in mortgage bonds trading for more than face value stand to lose as prepayments return their cash faster at par and curb interest.

Option-adjusted spreads, or OAS, capture projected average yields relative to benchmarks over a range of potential future interest rates that will influence homeowner prepayment speeds. Simpler yield spreads against benchmarks of a single maturity also fail to reflect that borrowers' principal is paid down both sooner and later than the average lives of the debt.

The Fed may already be the biggest buyer in the agency mortgage-bond market after starting in October to purchase new securities with proceeds from its past acquisitions of housing- related debt, including $1.25 trillion of home-loan notes through March 2010. It has bought $305 billion of securities under the reinvestment program, which it announced with the first round of its so-called Operation Twist for Treasuries.