For all the talk that Janet Yellen’s plan to shrink the Federal Reserve’s balance sheet will hurt Treasuries, U.S. mortgage bonds face a bigger test.
The securities are already lagging behind Treasuries for the first time since 2011. Investors are demanding 29 basis points of extra yield to buy the bonds instead of Treasuries, with the spread almost tripling from 2016’s low, Bloomberg data show. Firms including Allianz Investment Management and Federated Investors say the spread widening probably isn’t over.
“The market will be able to digest it, but you’ll need a higher yield to make buyers buy it,” said Marc Fovinci, head of fixed income at Ferguson Wellman Capital Management Inc. in Portland, Ore., which handles $4.8 billion. “The pace Yellen is talking about, it won’t be like flipping the light switch off. It’ll be like turning the dimmer switch down" on investor demand. The spread will probably double in a year, Fovinci said.
The Fed owns more than a quarter of the $6.86 trillion in agency mortgage-backed securities, and its holdings are likely to dwindle to almost nothing at some point because it only bought the securities as an emergency measure to prop up U.S. housing in the last recession. The Fed holds 18% of the publicly traded Treasuries market, and it’s likely to ultimately keep more of those holdings as part of its monetary policy arsenal.
The Fed’s effort to trim its balance sheet will mark the beginning of the end to its historic effort to gobble up mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae, concluding a program that created money for these companies to funnel into U.S. home lending.
Ben Bernanke, Yellen’s predecessor as Fed chief, began the purchases in January 2009 following a surge in mortgage spreads that pushed the differential over Treasuries to more than 190 basis points at the end of 2008. The figure was as low as 33 in January 2007, before the global financial crisis.
The Fed concluded its asset purchases in October 2014, though it kept reinvesting the principal repayments to keep the total size of its holdings steady. Now the central bank says it plans to begin trimming its balance sheet “relatively soon” by cutting back on those reinvestments. The Fed intends to start off with monthly reductions of $6 billion of Treasuries and $4 billion of mortgage securities, and gradually increase the amounts to $30 billion and $20 billion respectively.
Pre-crisis level
“It would not surprise me if mortgage spreads widen a little bit more from here because the market isn’t used to absorbing this,” said John Bredemus, Minneapolis-based head of capital markets at Allianz Investment, which oversees more than $700 billion worldwide. The spread may climb back to where it was before the crisis, he said.
Mitsubishi UFJ Kokusai Asset Management Co. senses a buying opportunity.
“We might add more mortgage bonds if spreads widen,” said Hideo Shimomura, chief fund investor for the firm, which oversees about $110 billion and is based in Tokyo. “The impact of the spread against Treasuries will be quite tame. The pace of the tapering will be quite slow.”
Along with bond yields, home-mortgage rates stand to climb as the Fed withdraws its support. The average 30-year home-loan rate has risen to 3.9% from the record low of 3.31% set almost five years ago. Thirty-year Treasuries yielded 2.78% as of 7:08 a.m. in London on Friday, having touched an all-time low of 2.09% in July 2016.
A report this month by the group of bond-market participants that advises the Treasury Department offered a few clues about how the central bank’s balance sheet will end up. Treasury holdings will probably be cut to $1.7 trillion by 2021 from a current level of around $2.5 trillion, the group said.
While the panel didn’t specify what the final stake in mortgage securities might be, it said proceeds from maturing holdings would probably be reinvested in Treasury bills. Yellen has previously said she would like the Fed to return to a balance sheet that’s comprised mainly of Treasuries.
Even though the balance-sheet reduction hasn’t even started, mortgage bonds are already lagging behind Treasuries. They have returned about 2.1% in 2017 versus 2.6% for sovereign debt, according to Bloomberg Barclays Indexes.
Mortgage bonds stand to suffer more than Treasuries, though it may take until next year for the taper program to affect these markets, said Donald Ellenberger, head of multi-sector strategies at Pittsburgh-based Federated Investors, which has about $360 billion in assets.
“I’d imagine the impact on the mortgage market, being smaller and less liquid, is going to be more significant,” Ellenberger said. “Mortgage bonds do look rich, because you do have a price- and yield-insensitive buyer that just buys and buys. Our multisector portfolios and funds have a very significant underweight to government mortgages.”
