Fed Exits Mortgages; Investors Should Enter Cautiously By Eleanor Laise Wall Street Journal 04-03-2010

Fed Exits Mortgages; Investors Should Enter Cautiously
By Eleanor Laise
The Wall Street Journal
April 3, 2010

The Federal Reserve has stepped back from the mortgage market. Does that mean small investors should step in?

Now that the central bank has halted its historic $1.25 trillion mortgage-purchasing program, launched 15 months ago to stabilize the housing market, one would expect prices in mortgage-backed securities to plunge, sending yields soaring.

That, in theory, would present a great buy-and-hold opportunity. But investors betting on that scenario might be disappointed.

Funds focused on "agency" mortgages, such as those guaranteed by Fannie Mae and Freddie Mac, are often tempting to investors looking for relative safety and better-than-Treasury yields. Such funds include Vanguard GNMA and Franklin U.S. Government Securities.

But these securities aren't the deal they once were. For a 30-year Fannie Mae mortgage, the "spread," or additional yield paid over a comparable Treasury, was just 0.6 percentage point at the end of March. Before the Fed started buying mortgage securities, the long-term average was 1.2 percentage points, according to Credit Suisse.

Without that buyer yields will plump up nicely, right? Not necessarily. During the purchase program, the Fed was crowding out many money managers who needed to find yield in other places such as asset-backed securities. Now those managers have smaller mortgage holdings than their benchmarks dictate. For example, Ronald Reardon, a principal at Vanguard Group who helps run actively managed bond funds, says mortgage allocations are "on the light side versus the benchmarks," due to better opportunities elsewhere.

With the Fed in retreat, many funds are likely to pile in, money managers and analysts say. While spreads may tick up, they probably won't expand more than 0.25 percentage point—and that is "definitely on the wide end," says Bryan Whalen, a managing director at fund firm TCW Group Inc.

And remember that government-backed mortgage bonds carry some risk. They typically yield more than Treasurys in part because investors can be repaid early if borrowers refinance. If a slew of borrowers suddenly refinance, that can leave investors with more cash and less yield than they had bargained for.

The mortgage market is highly sensitive to interest rates; small moves up or down can produce big swings in refinancing activity. When interest rates fall, refinancings rise, and so does this "prepayment risk." When interest rates rise, the reverse can happen. People stop refinancing, so investors keep the yield they have—but they miss out on the opportunity to exploit rising yields elsewhere.

Though few borrowers are refinancing right now, prepayment remains a risk. Recently, Fannie Mae and Freddie Mac announced buyouts of some delinquent loans, meaning investors get their money back early.

The best scenario for mortgage investors is a long period of relative calm. Yet many economists expect interest rates to keep rising in the next few years.

Instead, many managers say they find the best opportunities in nonagency mortgages, which lack government backing and carry more risk.

Many funds also have delved into risky "interest-only" mortgage derivatives. These holdings provide income based on mortgage interest, not principal. So if prepayments rise, they can get hit hard. The Oppenheimer U.S. Government Fund has about 3.5% of assets in interest-only securities, and manager Krishna Memani says he still finds them attractive. As spreads widen, he says, prepayment risk tends to goes down and interest-only securities tend to appreciate.

Interest-only derivatives tend to be quite volatile, and fund companies need to do a better job explaining them to investors, says Eric Jacobson, director of fixed-income research at investment-research firm Morningstar Inc.

Bottom line: Anytime investors take on additional risk to earn yields above Treasurys, they should mind the gap. Since such investments have performed strongly, says Curtis Arledge, managing director at BlackRock Inc., "You're getting into valuation levels where you need to do your homework."