US mortgage bonds feel strain of Fed pullback plans

The $7.2tn US mortgage market is on course for its worst showing in almost a decade, with analysts predicting that an imminent pullback in support by the central bank could exacerbate its poor performance this year.

The Bloomberg Barclays US Mortgage Backed Securities index has so far this year delivered a total return of minus 0.7 per cent — a reading not seen since 2013, when the Federal Reserve last spooked financial markets with plans to trim its previous bond-buying programme.

This time around, analysts and traders say the Fed’s careful communication has avoided another tantrum. But it has still been a tricky ride for those invested in the market.

The Fed is expected to announce a reduction to its $40bn of monthly purchases of mortgage bonds alongside $80bn of Treasuries in November, removing one of the biggest buyers in the market and last month helping to push the yield on mortgage bonds to its highest level since March 2020. Bond yields rise when prices fall.

“The MBS market is getting ready for the taper. It’s the one place you can see the taper being priced in most clearly,” said Edward Al-Hussainy, strategist at Columbia Threadneedle Investments. “Things are getting cheaper because the Fed is going to step down.”

Tapering is just the most recent hit to a market that has struggled under pressure from volatile interest rates this year.

Historic lows in interest rates prompted homeowners to pre-pay their mortgages early and refinance at new, lower interest rates, according to data from the Mortgage Bankers Association, cutting the amount of interest earned by investors in bonds backed by consumers’ mortgage payments.

As benchmark US Treasury note yields, which underpin mortgage rates, have begun to rise, prepayments have fallen, pushing out expectations of how long it will take homeowners to repay their mortgages. This particularly hurts low-coupon bonds that decline in price to compete with new, higher-coupon debt offering a better return to investors.

“It’s a sign of things to come,” said Scott Buchta, head of fixed-income strategy at Brean Capital. “If rates keep rising and mortgages get longer then the underperformance could keep showing up.”

However, some market participants note that while it has not exactly been smooth sailing for mortgages, they have performed better than other areas of fixed income. Investment-grade bonds slid in September, erasing earlier gains to deliver a year-to-date return of minus 1.1 per cent.

And while spreads, the difference in yield between Treasuries and other fixed-income assets, have risen on corporate bonds, they have declined in the mortgage market — an indication of short-term outperformance.

If spreads were to widen again, they could attract demand from money managers who have sat on the sidelines for much of this year.

Investment manager DoubleLine pushed its allocation to MBS in its Core Fixed Income Fund to the lowest levels ever earlier this year. But it has added to its position since the September Fed meeting, said Vitaliy Liberman, an MBS portfolio manager at the company.

Other investors are still waiting before they step back in.

“We don’t think we are being paid for the risk given that rates are going to continue to rise,” said Alan McKnight, chief investment officer at Regions Asset Management.

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