Mortgage Bond Rally Centers on Least Likely to Refinance: Credit Markets, by Jody Shenn and Alan Goldstein, Bloomberg.com


Investors in U.S.-backed mortgage bonds are shifting into securities tied to debt from homeowners who are the least willing or able to refinance as the Federal Reserve helps keep interest rates near record lows.

Fannie Mae-guaranteed securities with 5.5 percent coupons that are backed by 30-year mortgages with average balances of less than $85,000 have jumped to 2.4 cents on the dollar more than similar generic debt, according to FTN Financial. The gap has more than doubled from 1.1 cents in late July.

Homeowners with smaller loans don’t benefit as much from a drop in monthly payments as borrowers with bigger mortgages, while facing similar closing costs, and are thus less likely to refinance. Premiums for debt tied to mortgages with low balances have generally soared to the highest since at least 2004 after refinancing applications climbed to the most in 16 months.

“Prepayment protection is worth a lot more than what you’ve seen historically,” said Bill Bemis, a portfolio manager who oversees about $7 billion of securitized debt at Aviva Investors in Des Moines, Iowa. “Payups” for mortgage bonds filled with smaller loans “have gone a little bit too far” because it may take investors as long as two years to recoup such premiums through the extra interest payments by borrowers keeping their loans outstanding, he said.

Willing Fed

The Fed, which said yesterday it’s willing to ease monetary policy further to spur growth, has helped drive down borrowing costs by purchasing government and mortgage bonds, increasing its assets to $2.3 trillion from about $906 billion at the beginning of September 2008. U.S. two-year yields fell to a record low after the central bank’s statement.

Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of similar maturity government debt was unchanged at 171 basis points, or 1.71 percentage point, the lowest since May, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields averaged 3.512 percent, down from 3.566 percent.

The spread is narrowing at the same time as the number of U.S. companies at greatest risk of default dropped to the lowest level in two years, in part due to Federal Reserve efforts to bolster the economy, according to Moody’s Investors Service.

Companies rated B3, or six steps below investment grade, with a negative outlook or below that level declined to 195 as of Sept. 1 from a high of 288 in June 2009, Moody’s said. Clear Channel Communications Inc. and Energy Future Holdings Corp., formerly named TXU Corp., were among the biggest companies on the list.

IStar Debt

IStar Financial Inc., the commercial real estate lender seeking to restructure some of its $8.6 billion of debt, may seek bankruptcy protection after creditors blocked it from amending loans. IStar expects to begin meeting with creditors in coming weeks to discuss potential terms of a so-called pre- packaged bankruptcy, which wouldn’t occur until sometime next year, according to people familiar with the matter who asked not to be identified because the plan isn’t public.

Outside of bankruptcy, the company is weighing a proposal to extend maturities on its debt as well as a potential exchange offer, according to two people familiar with the situation. Andrew Backman, a spokesman for iStar, didn’t return a phone call or an e-mail message seeking comment.

IStar’s $501.7 million of 8.625 percent bonds due in 2013 fell 5.6 cents to 78 cents on the dollar, the lowest since March, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Chrysler Financial Corp. plans to issue $2 billion of bonds backed by auto loans this week in its first asset-backed securities sale since March, according to a person familiar with the transaction who declined to be identified because terms aren’t public. Toyota Motor Corp. is marketing $1.29 billion of similar debt, also slated to sell this week, a person familiar with that deal said.

Auto Loan Delinquencies

While delinquencies are down 23 percent from a year ago, late payments on auto loans rose to 2.1 percent in August, a 4.7 percent increase from the prior month, Standard and Poor’s said in a report.

Debt tied to auto lending accounts for a majority of asset- backed securities issued this year, or 53 percent of the $85.2 billion in sales, according to Bank of America Merrill Lynch data.

Bonds from DuPont Co. were the most actively traded U.S. corporate securities by dealers, with 167 trades of $1 million or more, Trace data show. The Wilmington, Delaware-based company’s $1 billion of 3.625 percent notes due in January 2021 rose 1.2 cent from its issue price on Sept. 20 to $101.04 cents on the dollar.

Bondholder Protection

Credit-default swaps on the Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, climbed 2 basis points to a mid-price of 108.7 basis points as of 5:23 p.m. in New York. Yesterday was the first full day of trading after index administrator Markit Group Ltd.’s semi- annual adjustment of companies included in the measure.

The Markit iTraxx Asia index of 50 investment-grade borrowers outside Japan increased 1.5 basis points to 122.5 basis points as of 8:22 a.m. in Hong Kong, Royal Bank of Scotland Group Plc prices show.

In emerging markets, the extra yield investors demand to hold corporate bonds rather than government debentures rose 22 basis points to 292 basis points, the highest since Aug. 31, according to JPMorgan Chase & Co. index data.

Leveraged loan prices rose for a 10th straight trading day, climbing 0.15 cent to 90.21 cents on the dollar, the highest since May 19, according to the S&P/LSTA U.S. Leveraged Loan 100 index.

Mortgage Refinancing

Mortgage refinancing can hurt bondholders by returning their money more quickly than anticipated. That’s particularly punitive if investors paid more than face value for their securities because of their relatively high coupons and instead receive their principal back at par.

The average rate on a 30-year mortgage fell to 4.37 percent last week, from this year’s high of 5.21 percent in April, according to McLean, Virginia-based Freddie Mac. The rate touched 4.32 percent earlier this month. Rates on loans in Fannie Mae’s 5.5 percent bonds average about 6 percent.

The Fed has held its target rate for overnight loans between banks at zero to 0.25 percent since December 2008. The 2-year Treasury note yield dropped 4 basis points to 0.43 percent after touching a record low 0.4155 percent.

Fannie Mae

Washington-based Fannie Mae’s 5.5 percent, 30-year securities fetch 106.44 cents on the dollar in the so-called To Be Announced market, where orders to buy debt can be filled with bonds with a range of characteristics through a type of futures contract, Bloomberg data show. That’s down from the record of almost 108 cents on July 27, though up from 104.72 cents on Dec. 31.

Mortgage-refinancing applications rose to the highest levels since May 2009 last month, according to data from the Washington-based Mortgage Bankers Association. While applications have declined, last week’s pace was more than double the level at the end of 2009.

“Right now, we have some pretty dramatic concerns about prepayments, so we’re looking at the specified pool market as an area where you can generate excess returns,” said Paul Colonna, who oversees $58 billion as chief investment officer for fixed income at GE Asset Management in Stamford, Connecticut.

‘Seasoned’ Debt

General Electric Co.’s investment arm likes mortgage bonds backed by lower-balance loans, and “seasoned” debt, which also offers protection against homeowners falling out of the pools after turning delinquent, Colonna said.

Aviva’s Bemis said he’s willing to pay for bonds backed by loans made in recent months, whose borrowers “are much less likely to want to go in anytime soon and refinance again.”

He also favors debt tied to property investors and homeowners owing the most relative to their properties’ values who will find it more difficult or expensive to qualify for new loans. While the latter debt may not prepay as slowly as smaller loans, it may cost only 0.5 cent on the dollar more than generic securities, he said.

Some types of mortgage bonds are in “bubble territory” in relation to the TBA market, according to Tae Park, a money manager in New York who oversees mortgage-bond investments at Societe Generale SA, France’s second largest bank.

“This bubble will last as long as the refi uncertainty continues,” he said. “It’s like when people are willing to pay-up for bottled water, when the tap water is from an unknown source.”

Hubbard, Mayer

In a New York Times op-ed this month, Columbia University’s Glenn Hubbard and Chris Mayerproposed a new program through which the government would direct Fannie Mae, Freddie Mac and federal agencies such as Ginnie Mae to streamline refinancing. Hubbard, who served as chairman of the Council of Economic Advisers under President George W. Bush, is dean of the Columbia Business School, where Mayer is a senior vice dean.

Higher payups “certainly illustrate the anxiety mortgage investors are feeling about government policy,” said Julian Mann, who helps oversee $5.8 billion in bonds as a vice president at First Pacific Advisors LLC in Los Angeles.

Changes in the mortgage market amid the worst U.S. housing slump since the Great Depression are eroding the value of some typical characteristics investors seek for “prepayment protection,” Mann said. Bonds of older 15-year mortgages with low balances, for example, are refinancing faster than First Pacific Advisors expected, he said.

Mortgage bankers and brokers pursuing “slam dunk approvals,” rather than spending as much time on potentially more lucrative larger loans, are responsible, Mann said. The 15- year debt tends to be taken out by borrowers with better means to pay it off than 30-year loans, and pays down more quickly, giving homeowners lower loan-to-value ratios when they seek to qualify for a refinancing, he said.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net.

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