At play are a cooling housing market, rising interest rates and accounting issues.A
A cooling housing market, rising interest rates and
regulatory scrutiny have bond fund managers and fixed-income
strategists keeping a watchful eye on the direction of the $5.8
trillion mortgage-backed securities market.
The vast size of what has become the largest
fixed-income sector in the world makes what happens there important to
just about anyone who invests in bonds or bond funds. Fueled by a real
estate boom and insatiable demand for mortgages, the mortgage
securities market has almost doubled in size over the last eight years
and now eclipses the $4.1 trillion space occupied by Treasuries.
Although most financial advisors don't invest directly in mortgage
bonds, many of their clients have a big stake in the direction of the
securities that are issued or guaranteed by Fannie Mae, Freddie Mac or
the Government National Mortgage Association through diversified,
investment-grade bond funds. Their triple-A ratings and a yield premium
over Treasuries of about 1.0% to 1.5% (in exchange for the uneven and
unpredictable cash flow due to mortgage prepayments) makes them a draw
for many investors and a haven for investment grade bond funds.
The Vanguard Total Bond Market Index Fund has more than one-third of
its assets in government mortgage pass-through securities, and the $90
billion PIMCO Total Return Fund had 62% of its portfolio invested in
them at year-end. At more narrowly focused government bond funds that
invest in a mix of government issues, including U.S. Treasuries,
higher-yielding mortgage-backed securities often account for the lion's
share of assets.
But some analysts and portfolio managers say the stage is being set for
a less appealing environment for mortgage-backed bonds this year. In a
recent report, Lehman Brothers analyst Srinivas Modukuri noted that the
risks from "weak-looking demand and a slowing housing market justify an
underweight position on mortgage bonds in 2006." The report also noted
that higher short-term interest rates have made it harder for banks to
profit from the difference between the low rates they pay on deposits
and the higher rates they reap from investing in mortgage bonds
yielding 5.5% or more. The banks are turning to other alternatives such
as higher-yielding business loans and slowing down their investments in
mortgage securities.
Supply also has been an issue. The rush of home lenders eager to fuel
the housing boom created a flood of new issues last year that put
pressure on bond prices. And when regulators directed Fannie Mae and
Freddie Mac to shore up their balance sheets, those companies dumped
billions of dollars' worth of bonds into the marketplace when they
downsized their vast portfolios of mortgage-backed securities.
Don Quigley, co-portfolio manager of the Julius Baer Total Return Bond
Fund, says that while he isn't too worried about housing prices-like
several other managers interviewed for this article, he believes they
will cool down rather than collapse-he is concerned about the
possibility of rising interest rates. If that happens, mortgage bonds
would be hit harder than some other segments of the fixed-income market.
"Rising rates slow down prepayments, and that extends the duration of a
mortgage-backed security," he explains. "A 150-basis-point increase in
rates would have a greater negative impact on a mortgage-backed bond
than it would on a Treasury of the same duration." Quigley, whose fund
is slightly underweight in mortgage-backed securities relative to its
benchmark, believes that there is a "decent risk" that inflation will
run higher than many people expect.
Bill Irving, who runs several fixed-income funds at Fidelity, says his
outlook for the agency securities this year is "not a positive one,"
and the diversified government bond fund he manages has an underweight
position in the securities. Irving is uncomfortable with the threat of
"lukewarm demand and heavy supply" that hangs over the market.
"With the yield curve so flat, people aren't using hybrid ARMs any
more, so there has been a heavy influx of bonds backed by 30-year,
fixed-rate mortgages," he says. "At the same time, a flat yield curve
will discourage bank buying and the agencies are likely to limit their
purchases as well." The one wild card he sees is a possible pickup in
overseas demand as foreign buyers diversify away from Treasuries.
Demand from those foreign buyers is one reason that yields on Ginnie
Maes are unusually low right now. Usually, those bonds yield about five
to ten basis points less than those issued by the two other agencies
because they carry a direct government guarantee of timely payment of
interest and principal. The government stands behind Fannie Mae and
Freddie Mac mortgage securities, but does not explicitly guarantee
them.
But strong demand from foreign buyers and others has widened the spread
to 25 to 30 basis points. "If an investor is choosing between a pure
Ginnie Mae fund versus a broader government bond fund, the latter would
be the preferable alternative," says Irving.
Other fixed-income managers believe mortgage-backed bonds are
competitive with other fixed-income investments and that their prices
are low enough, and yields high enough, to warrant a slightly
overweight position in fixed-income portfolios. "Right now, a current
coupon mortgage bond yields about 5.75%, versus a little over 5% for a
double-A-rated corporate bond," says David Ballantine, principal and
fixed-income strategist at Payden & Rygel. "Compared to corporate
bonds, mortgage-backed bonds are attractive at current levels."
Ballantine says the firm's fixed-income portfolios are "modestly
overweight" in that sector of the market, which is currently yielding
about 130 basis points more than ten-year Treasuries. Over the last
twelve months, the yield premium over Treasuries has been as low as 100
basis points and as high as 140 basis points.
Ballantine notes that last year, a softer housing market and rising
interest rates caused a drop in prepayments. When the housing market is
hot, people move, their old mortgages are paid off, and mortgage bond
investors get their money back more quickly. When they reinvest it,
they must often do so at lower rates. The opposite happens when the
housing market softens, or when interest rates rise and homeowners
don't refinance as much.
"The biggest risk with mortgage bonds is prepayment risk, and that is
fairly low right now," he says. "The best environment for
mortgage-backed securities is one in which interest rates are stable.
Our view is that rates are relatively range-bound, so the goal now is
to maximize coupon income."
However, he adds, Treasury securities could become a more attractive
option if long-term bond rates rise unexpectedly. "If you think the
ten-year Treasury bond rate is going to rise by more than 50 basis
points or so, you should probably go with Treasuries," he says.
Richard Schlanger, vice-president and portfolio manager for several
bond funds at Pioneer Investments, thinks mortgage-backed bonds should
perform "pretty well" this year, delivering total returns in the 3% to
5% range. "Housing price appreciation will probably slow down a bit,
but this should be a trend of moderating escalation rather than
deterioration," he says. "The last thing the Fed wants to do is to
burst the housing bubble because the economy would be in dire straits
if that happened."
He believes that the Fed funds rate should top out at 4.5% to 5% this
year, and that rates could begin heading down again "within six months
of the last tightening." In an environment of relatively stable
mortgage rates, Schlanger believes prepayments should remain at current
levels or decline slightly. "The bulk of outstanding Ginnie Mae
Securities have coupons of 5% to 5.5%, so refinancing should be
minimal," he says.
Excess supply should be less of an issue this year than it was in 2005,
he says. "Regulators have deemed Fannie Mae and Freddie Mac as
adequately capitalized. I think they will be looking to grow their
balance sheets going forward and they could be back in the market this
year."
Quigley isn't convinced that Fannie's and Freddie's troubles are over.
"Even if reforms are instituted you still have headline risk, and bad
news could have a negative impact on mortgage bond prices," he says.
"Over the longer term, I'm also concerned that regulators will mandate
that they control their balance sheets. If that happens, they will be
buying a lot less bonds for a long time."
But James Kauffmann, head of fixed income at ING Investment Management,
says that a recent influx of foreign buyers should "more than
compensate" for lower agency demand. And with the wide variety of
mortgage products available, mutual fund managers have lots of ways to
help control volatility and to limit the impact of mortgage
prepayments.
"Overall, the market looks more stable and requires less hedging than
it has in years," he says. "Over the long haul, this is a good asset
class with little or no credit risk."