Agency Mortgage Bonds Suffering

Agency Mortgage Bonds Suffer Worst Year in More Than Decade

Agency mortgage bonds are poised for their worst year in more than a decade, with supply up sharply and investors flocking to the safety of Treasurys.

Most of the pressures have been the indirect result of the subprime mortgage credit crunch. The $4 trillion agency mortgage bond sector - made up of mortgage bonds guaranteed by housing finance agencies Fannie Mae and Freddie Mac - is characterized by minimal credit risk, thanks to these guarantees.

But the lack of credit risk - which sets these bonds apart from subprime mortgage bonds - hasn’t helped agency mortgage bonds in 2007. As measured by the Lehman Brothers mortgage index, agency mortgage bonds logged negative 2.15 percentage points in excess returns over Treasurys in 2007 through Nov. 28.

That year-to-date performance is the worst in more than 10 years, according to the Lehman index. In 2006, mortgage bonds posted a positive 1.22 percentage points in excess returns.

If anything, the fact that agency mortgage bonds carry minimal credit risk has worked against the sector, said Walt Schmidt, manager of structured products strategy for FTN Financial in Chicago, because investors facing losses in other areas _ for instance, losses related to subprime mortgage-backed securities _ have been selling these very easily trade-able mortgage bonds to raise cash.

“People have to sell whatever they can,” when they have to cover losses, Schmidt said, and since agency mortgage bonds are so easy to sell, they have been an instrument of choice this year for investors in need of cash.

And on top of the pressure to sell, there’s been increasing supply in the agency mortgage bond sector. That, too, has been an indirect consequence of the subprime-mortgage crunch, as banks are more eager to make loans that can be sold into the secondary market. And with risk appetite so low among investors right now, that means banks have to originate more loans that qualify to be guaranteed by the housing finance agencies.

In 2007, in contrast to 2006, when lending standards were quite loose, a “larger and larger share” of the mortgage loan market has been shifting to conservatively underwritten loans made to borrowers with good credit and the ability to make substantial down payments, said Ajay Rajadhyaksha, head of U.S. fixed income strategy for Barclays Capital in New York.

Mortgage borrowers, too, have grown more conservative as fresh headlines appear almost daily about the risks of adjustable-rate mortgages. And many have chosen to refinance from floating-rate mortgages into new fixed-rate mortgages if they can, adding to the already heavy supply in agency mortgage bonds.

In 2007, fixed-rate issuance will be the highest it has been in the last four years, Rajadhyaksha said.

Even though agency mortgage bonds carry minimal credit risk, they are still seen as having more credit risk than, say, U.S. Government bonds.

And as subprime credit problems have spread to the farthest reaches of U.S. fixed income, investors have fled to the safety of Treasurys at the expense of other fixed-income sectors. Agency mortgage bonds are one of those sectors that have suffered as a result.

“When a lot of market participants are worried, they flock to Treasurys and leave everything else behind,” said Art Frank, head of mortgage-backed securities research for Deutsche Bank in New York.

Agency Mortgage Bonds Suffering
Associated Press