Mortgage Bond Spreads at Widest in Five Months: Credit Markets

By Jody Shenn


May 5 (Bloomberg) -- Yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates climbed to the highest in five months relative to Treasuries as Europe’s worsening government finances lead investors to shun all but the safest assets.

Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds widened about 0.03 percentage point to 0.78 percentage point more than 10-year Treasuries as of 11:57 a.m. in New York, up from 0.68 percentage point on April 26 and the biggest gap since Dec. 8, according to data compiled by Bloomberg.

Even with U.S. promises to pump unlimited capital into the two government-charted companies through 2012 to ensure they can meet $4.6 trillion of guarantees on housing assets, speculation that Greece’s debt crisis will infect other European countries is driving investors to the safety of Treasuries and making interest rates more volatile, harming their mortgage bonds.

“You hate to assign everything to Greece, but any time you get sovereign-debt risk issues, I think that gives MBS investors pause,” said Walt Schmidt, a mortgage-bond strategist in Chicago at FTN Financial Capital Markets. “It’s not that far- fetched” to think that if multiple countries default, there’s a chance Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac eventually could too, he said.

The widening in spreads has been driven by “fast-money players” such as hedge funds and traders, rather than any retreat by longer-term investors, Schmidt said. The average rate on a typical 30-year fixed-rate mortgage was 5.06 percent last week, up from a record low of 4.71 percent in the week ended Dec. 3, according to Freddie Mac. It reached a high last year of 5.59 percent in June.

Fed Program Ends

Yield premiums on the securities guaranteed by Fannie Mae touched a record low of 0.59 percentage point on March 29, two days before the end of a Federal Reserve program that purchased $1.25 trillion of agency mortgage bonds. Yields have fallen to 4.35 percent, from 4.51 percent on March 31, amid lower benchmark rates.

Elsewhere in credit markets, the extra yield investors demand to own company debt instead of Treasuries rose 4 basis points to 153 basis points, or 1.53 percentage point, Bank of America Merrill Lynch’s Global Broad Market Corporate Index shows. That’s the biggest one-day increase since March 30, 2009, when spreads widened 5 basis points to a record 511. They have widened 11 basis points from the 2 1/2-year low on April 21.

Average yields fell 4.4 basis points to 3.914 percent, the lowest since April 27, the index shows.

Greece Protests

The cost of protecting Greek bonds from default rose the most in a week amid investor concern the 110 billion-euro ($143 billion) aid package reached May 2 may not solve the nation’s deficit crisis or prevent contagion to Europe’s debt-ridden economies.

Credit-default swaps on Greece surged 77.5 basis points to 842 basis points, according to CMA DataVision prices. Greek protests against government austerity measures turned fatal when three people were killed in a fire set by demonstrators in an Athens building as protests escalated against 30 billion euros of additional wage cuts and tax increases pledged in exchange for the bailout.

“It would appear that the market is still not convinced that sovereign risk is yesterday’s news,” Gary Jenkins, the head of credit strategy at Evolution Securities Ltd. in London, wrote in a note to investors. “I would bet there are a lot of very worried EU officials.”

Bond Risk

The Markit iTraxx Europe Index of swaps on 125 companies with investment-grade ratings, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, jumped 8 basis points to a mid-price of 105.75, JPMorgan Chase & Co. prices show.

The Markit CDX North America Investment Grade Index Series 14 increased 4 basis points to a mid-price of 101.7 as of 12:10 p.m. in New York, according to Markit Group Ltd. The index typically rises as investor confidence deteriorates and falls as it improves.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The extra yield investors demand to own emerging-market bonds over U.S. Treasuries rose 11 basis points to 291, the highest since Feb. 26, according to JPMorgan’s EMBI+ Index.

Fannie Mae

The $5.4 trillion market for so-called agency mortgage securities includes those guaranteed by Fannie Mae and Freddie Mac, and federal agency Ginnie Mae. Current-coupon bonds, or those trading closest to face value, are guiding rates on almost all new U.S. home lending following the collapse of the non- agency market and a retreat by banks.

In March, the Fed completed a 15-month program intended to reduce financing costs by decreasing the supply of home-loan securities in the market, driving down yields. That month, the central bank also ended a program in which it bought $172 billion of the corporate debt of Fannie Mae and Freddie Mac and the Federal Home Loan Bank system, a series of cooperative lenders to financial companies.

Spreads on mortgage bonds also narrowed while the Fed was buying because interest-rate “volatility collapsed,” Curtis Arledge, chief investment officer for fixed income at BlackRock Inc., the world’s largest money manager, said in an April 13 interview.

Interest-Rate Volatility

The sovereign-debt crisis has reversed that trend, with a Barclays Capital index of expectations for interest-rate volatility climbing 15 percent through yesterday from April 16. The measure, based on prices for so-called swaptions, had declined almost 15 percent this year to a 12-month low.

Swaptions give buyers the option to enter interest-rate swap contracts at later dates. Swap rates are the fixed amounts investors pay in exchange for receiving floating rates linked to short-term borrowing costs.

Greater volatility harms mortgage-bond prices because it makes bigger rises or drops in rates more likely, pushing refinancing and other sources of prepayments on the underlying loans either much higher or lower than expected.

Prepayments that are higher than planned typically return more of investors’ money when new investments carry lower yields, and may cause investors losses if they bought bonds above face value. Refinancing rates that are lower than planned cause investors to receive their money back slower, as higher market yields make their investments less attractive.

Home-Loan Securities

Events in Greece have done little to curb a rally in non- agency home-loan securities, which have in some cases more than doubled from record lows set in early 2009.

A Markit ABX index of credit-default swaps tied to 20 subprime-loan bonds rated AAA when created in the first half of 2007 has climbed 34 percent since March 15 to 46.38 yesterday, near the highest since October 2008, according to London-based Markit.

The index fell as low as 23.1 in April 2009. Delinquencies and defaults on the loans to which the ABX indexes are tied fell in March by about 3 percent, declining for a second straight month in part because of “seasonal trends” and “high levels” of debt modifications, according to an April 26 report by Credit Suisse.

PrimeX credit-default swap indexes, created April 28 and linked to prime-jumbo mortgages, have also advanced, with three of four ending yesterday at or near their highest levels, according to Markit’s website.

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