By Al Yoon
Mortgage-backed securities investors considering their next best trades as they watch the Federal Reserve consume their market are sticking pretty close to home.
Yields in the $5 trillion agency MBS market have plunged since the Fed said it would embark on open-ended purchases of the securities on Sept. 13. Less than three weeks later, Fannie Mae's (>> Federal National Mortgage Association) current coupon MBS yields of 2% represent a 25 basis point advantage to the 10-year Treasury note, near the record low spread of 19 basis points last month. Before the quantitative easing announcement, the spread was close to 80 basis points.
Falling yield spreads haven't sparked a flight from MBS, which are expected to benefit from Fed support. But some investors have begun testing the waters in other markets, attempting to closely match the MBS characteristics in what analysts call "mortgage replication."
The buzz has turned attention of some MBS investors to callable agency bonds, part of the $2 trillion market for the unsecured debt of Fannie Mae, Freddie Mac (>> Federal Home Loan Mortgage Corp) and the Federal Home Loan Bank system. Like agency MBS, agency callable bonds carry implicit government backing, so there is little credit risk. Also like MBS, the bond can be called, or stripped away from the investor before maturity, a risk that that is compensated with higher yields.
"QE is massively boosting MBS valuations and that's induced mortgage investors to consider not just spread alternatives but those with comparable risk profiles," said Christopher Sullivan, chief investment officer at the United Nations Federal Credit Union.
As September came to a close, Citigroup (C) traders reported the "year's largest allocation trade out of mortgages into callable agencies," including a $1.5 billion purchase by a single investor, according to a note circulated to investors. A Citigroup spokesman declined to comment.
Mr. Sullivan said he is adding to that trade that he started before the Fed launched its latest QE.
While managers may be just sniffing around, their buying is having some impact, analysts said. Since late September, yield spreads on seven-year callable agency debt narrowed 1 basis point to 5 basis points below the London interbank offered rate, analysts at Nomura Securities said on Friday. Meantime, the spread for MBS with similar characteristics increased to 15 basis points below Libor, from 31 basis points below the benchmark.
Issuers are trying to meet increased demand, though that has been tough as shrinking investment portfolios of Fannie Mae and Freddie Mac mean they have less need to sell the debt. The demand for callable debt was so strong last Wednesday that Freddie Mac filled its debt issuance needs by 8:50 a.m., an unusually early time, according to a trader at a primary dealer.
The latest increase in agency callable debt issuance also coincides with the Sept. 13 Fed meeting announcing the quantitative easing, probably reflecting demand from MBS investors, James Ma, an analyst at Barclays, said in a research note on Friday. The agencies have issued about $15 billion in callable debt in each of the past four weeks, about twice the average of the previous four weeks, according to Barclays.
Freddie Mac and Fannie Mae spokesmen declined to comment. David Messerly, a spokesman for the Federal Home Loan Banks' office of finance, confirmed an increase in interest for long-term callable debt from traditional MBS investors.
The trade has its drawbacks, however, and not only because investors would miss out on the tailwind of Fed buying. The supply of callable debt is small by comparison, and callable bonds don't have the same interchangeable qualities and attractive financing terms that make the mortgage-backed bond market one of the world's most-actively traded debt markets.
What's more, Fannie Mae and Freddie Mac are also "incredibly efficient" at calling their securities when it is to their benefit, said John Kerschner, global head of securitized debt at Janus Capital. By contrast, hurdles to mortgage refinancing mean that principal prepayments on MBS will be relatively moderate, he said.
Scott Wede, head of U.S. securitized products trading at Barclays, said investors aren't feeling too pressured to find alternative investments.
"So far we haven't seen a lot of people take profits in the MBS market," Mr. Wede said. "Overall, people think it's too early."
Write to Al Yoon at [email protected]