Halloween is still several days away but the mortgage market has decided to spook the corporate bond market a bit early. The Mortgage-Backed Securities (MBS) sector was logically the first to come under scrutiny from the mortgage foreclosure problem but oddly enough, it is the Corporate Bond Sector that grapples with potential ramifications of the mortgage foreclosure mess. The possibility of “put-backs,” the process by which banks will be forced to repurchase a witches brew of non-performing loans and foreclosed properties back onto their balance sheets, has led to modest weakness in Corporate Bonds, concentrated primarily among bonds issued by financial companies.
The MBS sector will be largely unaffected by uncertainties regarding mortgage foreclosures. The bulk of the MBS sector, $6.7 trillion out of total MBS market of $8.9 trillion, is comprised of agency MBS issued by the government sponsored agencies of Ginnie Mae, Fannie Mae, and Freddie Mac. The agencies are required to purchase delinquent loans out of the loan pools that back mortgage-backed bonds no longer than 120 days after the loan becomes delinquent, long before foreclosure. The loan is purchased from the pool at par value so the bond investor does not suffer a loss, a factor that contributes to the AAA-rating of agency MBS.
Look For Delays
Delays in foreclosures may have a small impact in the smaller, non-agency MBS sector. Non-agency MBS, issued by banks and other financial institutions, may suffer delays in cash flow payment to investors. However, this impact is difficult to gauge as foreclosed loans are disclosed to bond investors well in advance and often treated as defaulted (with an assumed recovery value), all of which is factored into the price of the bond. The impact to non-agency bonds is likely on a case-by-case basis and not a market-wide event. Furthermore, since non-agency MBS are not included in popular bond market benchmarks, such as the Barclays Aggregate Bond Index or the sector specific Barclays U.S. MBS Index, non-agency bond exposure is relatively limited among bond mutual funds averaging less than 1%, according to Morningstar data.
However, uncertainty over mortgage foreclosures has spooked the Investment-Grade Corporate bond market. The yield premium, or spread, to comparable Treasuries has widened sharply over the past two weeks pushing overall investment-grade spreads wider in the process (chart 1). Yield spreads stabilized last week as strong earnings reports helped offset mortgage put-back fears.
The mortgage foreclosure issue will take time to resolve and may lead to continued volatility. Aside from possibly taking mortgage loans and/or properties back onto their balance sheets, uncertainty over potentially higher overall foreclosure costs and litigation risks may keep an eerie fog over the financial sector of the investment-grade corporate market. Since the banks and financial institutions are at the heart of the day-to-day functioning of capital markets, the impact of the corporate bond market on the financial sector is important to follow.
Ultimately, we believe other positive factors such as robust earnings, improving credit quality, and the prospect of large-scale bond purchases by the Federal Reserve will keep the goblins in check and outweigh the potential negative impacts from the mortgage foreclosure problem. Last week, Bank of America and Wells Fargo, two of three largest banks in terms of residential mortgage loans, offered a treat rather than a trick by reporting better-than-expected earnings helping to allay fears of mortgage put-backs. Early bank earnings reports, on balance, show that banks were able to release reserves held against potential losses as problem loans declined. In our view, an increase in required reserves over the prior quarters coupled with a decline in problem loans put the large banks in a position to weather the storm should mortgage put-backs become a reality. It is also worth noting that potential problems will likely be limited to the largest banks and not to financial institutions across the board as the recent Corporate Bond action suggests.
No Significant Risk
We do not see mortgage put-backs leading to any significant default risk for bond investors. In a potential signpost for the large banks, Moody’s stated that added expenses that may result from the mortgage foreclosure problem are not expected to adversely affect the ratings of Bank of America Corporate Bonds, the largest holder of residential mortgage exposure.
Furthermore, the prospect of another round of quantitative easing by the Fed in the form of large-scale bond purchases is likely to be a positive for corporate bond investors. We believe the Fed bond purchases will help push Treasury yields even lower and forcing more investors into higher-yielding Investment-Grade and High-Yield Corporate Bonds. We also believe the positive forces of good earnings and Fed purchases may outweigh the potential ghoulish impact of the mortgage foreclosure problem over the longer term.
- This report was prepared by LPL Financial. 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.
- 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.
- 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 a fund shares is not guaranteed and will fluctuate.
- An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.
- Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.
- 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.
- 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.
- This Barclays Aggregate 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).