August has so far been a very good month for high-quality bond investors but Mortgage-Backed Securities (MBS), issued by the government agencies Ginnie Mae, Fannie Mae, and Freddie Mac, have not participated in the latest leg of the bond market rally. Even after Friday’s sell-off in the bond market, the high-quality bond market, as measured by the Barclays Aggregate Bond Index, was up 0.7% for the month through last Friday August 27, 2010 led by Treasuries, which were up 1.2% according to Barclays Treasury Index data.
While MBS are up 5.5% year-to-date through the end of July, the MBS market is down 0.15% so far in August (through August 27), as measured by the Barclays Mortgaged-Backed Securities Index. Holders of these high-quality bonds are likely scratching their heads as to why MBS prices are unchanged and in many cases lower, in August. On average, the past two weeks, in particular, have witnessed slightly lower prices and higher yields despite the impressive strength exhibited by the Treasury market. The average MBS yield advantage, or spread, to comparable Treasuries has increased to the widest level in a year.
Refinancing on the Brain
A potential refinance wave, and not credit quality concerns, is pressuring MBS holders. Since MBS are refinanced at par, a higher level of refinancing increases the risk that premium price bonds may be redeemed at par. The MBS market typically adjusts fluidly to the level of refinancing but the speed of the recent decline in Treasury yields has caught the market off-guard.
In addition, 4.5% coupon MBS, which are mostly backed by 5% interest rate residential mortgages and comprise the largest segment of the MBS market, have just entered the refinance zone. Refinancing concerns have escalated over the past two weeks given the spike in the Mortgage Bankers Association Refinance Index.
Earlier in the month, two other factors played a minor role in MBS weakness but they were far less impactful in our view:
- Reports of a new loan forgiveness program emanating from Washington
- The future of the Government Sponsored Enterprises (GSEs)
More Government Programs
Speculation regarding a new principal forgiveness program from Washington for borrowers whose loan balance exceeds the value of their home caused mild market jitters. While such a program would indeed be problematic for bondholders, as it would likely entail investors of premium-priced bonds having their bonds redeemed at par (100), we view it as highly unlikely. The cost of such a program would be enormous and add to the fiscal deficit at a time when deficit scrutiny is at a fever pitch. Furthermore, the program might create a moral hazard by incentivizing borrowers who are underwater, but current on their loan payments, to stop making payments. This would not be a desirable outcome. We view any forgiveness program as highly unlikely.
On August 17, the U.S. Treasury Department along with the U.S. Department of Housing and Urban Development (HUD) sponsored a conference on the future of housing finance with the intent to address the future of the GSEs, particularly Fannie Mae and Freddie Mac. The conference created modest uncertainty as market participants questioned whether it signaled the start of the government’s slow withdrawal of support for both Fannie Mae and Freddie Mac. However, the conference turned out to be mostly political theater with no solutions proposed. In our view, the only take away from the conference was the Obama Administration’s intent to maintain some sort of government guarantee, perhaps a partial guarantee similar to the role provided by a municipal bond insurer. The administration will convene again next February to discuss next steps. The housing finance problem is very complex and given the snail’s pace at which the issue is being addressed, we believe full government support for the GSEs may remain in place for years.
Underperformance On the Way
It is not uncommon for non-Treasury sectors to underperform Treasuries during flight-to-safety induced rallies, but refinance concerns are causing a particular disparity in August. If Treasury yields decline further or even stabilize at current levels, we expect MBS to continue to underperform within the high-grade bond market. The uncertainty over refinancing may likely persist over the near-term. Conversely, the now cheaper valuations will provide a buffer when Treasury yields eventually reverse course higher. For longer-term investors the cheaper valuations may provide an attractive entry point. Among high-grade bond sectors, we continue to prefer Investment-Grade Corporate Bonds to MBS, but MBS, despite near-term risks, remain our preference for investors focused solely on government bonds. Like all high-grade bond sectors, investors should be aware that the now lower level of yields implies lower returns going forward than what investors have been accustomed to in 2010.
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
- The Barclays Mortgage-Backed Securities Index includes 15- and 30-year fixed-rate securities backed by mortgage pools of the Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Federal National Mortgage Association (FNMA).
- The Barclays Treasury Index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include t-bills (due to the maturity constraint), zero coupon bonds (Strips), or Treasury Inflation Protected Securities (TIPS).
- The market value of Corporate Bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
- Past performance is no guarantee of future results.
- Mortgage-Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
- GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
- The Mortgage Bankers Association of America Refinance Index covers all mortgage applications to refinance an existing mortgage. It is the best overall gauge of mortgage refinancing activity. The Refinance Index includes conventional and government refinances, regardless of product (FRM or ARM) or coupon rate refinanced into or out of.