The Federal Reserve's plan to buy $40 billion a month in
agency mortgage-back securities until job growth rises adds
upward pressure to mortgage-backed securities. The question is
how much?
If the Fed has guaranteed demand for home loans through MBS,
or financial products with exposure to cash flows from mortgage
loans, should you be buying them too? The Fed hopes to push down
mortgage rates and boost home prices to prompt people to buy
homes and spend the equity on consumer goods.
For some market strategists, Fed Chairman Ben Bernanke's plan,
announced last week, invokes the old adage: You can't fight the
Fed.
ETFs tracking MBS reacted positively Thursday after Bernanke
dropped the QE3 bomb to keep interest rates at rock-bottom
through 2015.
IShares Barclays MBS Bond (
MBB
) -- the largest ETF of its kind with $5.68 billion in assets --
rose 0.46%. It marked the largest one-day price gain in 13
months. It currently yields 3.17%. It holds primarily 30-year
fixed, highly-rated, securities issued by three government
enterprises: Government National Mortgage Association (GNMA or
Ginnie Mae), Federal National Mortgage (FNMA or Fannie Mae), and
Federal Home Loan Mortgage Corp. (Freddie Mac). The ETF settled
back a bit on Friday and Monday.
Vanguard Mortgage-Backed Sector Index ETF (
VMBS
), yielding 1.14%, andSPDR Barclays Cap Mortgage Backed Bond (
MBG
), yielding 1.3%, also jumped Thursday.
"They will see further price increases, and yield declines,
each month that the Fed buys $40 billion worth," said John
Graves, editor of "The Retirement Journal." "The Fed has
guaranteed a market for these securities, as they have for $2
trillion in U.S. bonds."
Bond king Bill Gross already had put half of his $272.5
billion Pimco Total Return -- the world's largest bond fund -- in
MBS. The founder and co-chief investment officer at Newport
Beach, Calif.-based Pimco told Dow Jones he knew the high
unemployment rate and slow recovery would make the Fed provide
more stimulus. He believes the Fed's easy money policy could last
for years.
Marginal Impact
But some market strategists doubt MBS ETFs have much upside
potential and say the Fed's impact will be marginal.
"The mortgage-related portion of the U.S Investment Grade Bond
Index is just over $8.0 trillion," said Wayne Schmidt, chief
investment officer at Gradient Investments in Shoreview, Minn.
"The Fed program is targeting 0.5% of the total pool of agency
mortgage-backed securities. If the program continued for one
year, their purchases would equate to about 6% of the total
market."
Mortgage rates are already at 30-year historic lows. If they
fell further, they would be a less attractive investment than
government bonds, which carry considerably less risk with
comparable yields.
The average 30-year fixed-rate mortgage hovers near 3.52% and
the average 15-year yields 2.93%, according to Bankrate.com.
Theoretically that's the most yield investors can earn on them.
By comparison, 30-year Treasury bonds yielded 3.09% as of Friday.
Twenty-year bonds yielded 2.68%.
"Investors still would need some risk premium on MBS, given
the nature of the security," said Matt Reiner, portfolio manager
at Wela Strategies in Atlanta.
MBS are subject to prepayment risk that could lead to losses.
If interest rates fall, homeowners are likely to refinance to
reduce rates.
"The loss comes about because investors only receive par when
mortgage holders refinance their mortgages," explains Keith
Newcomb, portfolio manager at Full Life Financial in Nashville.
"For instance, 4.5% (yielding) MBS are trading around 108, and
when a mortgage inside is refinanced, the owner of the MBS only
receives 100. If the owner paid a premium, that prepayment
results in a capital loss, and forces the investor to reinvest at
the currently lower prevailing yield."
But banks have been very uptight about lending and there may
be fewer refis and prepayments than expected, Newcomb said.
If interest rates rise, MBS prices will fall. But that's
unlikely. "Since the Fed will keep the interest rate low through
2015, the risk of buying these MBS bonds now is the refinancing
risk and the leverage," said Tahar Mjigal, director of risk
management at International Capital Management in Dallas. "This
could trigger a wave of refinancing."
Unfortunately, homeowners can't refinance to take advantage of
lower rates if their homes are underwater. As of the second
quarter, about 22.3% of properties are worth less than what their
owners paid for them, according to CoreLogic. This amounts to
10.8 million homeowners. Another 2.3 million have less than 5%
equity in their homes, which is considered near negative
equity.
There's no guarantee the Fed's plan will do what it intends.
QE3 opponents note the Fed already tried to jump-start the
economy via QE1 and QE2, which failed by most estimates.
"Loose monetary policy created the housing and stock bubbles
of the last decade, the bursting of which almost blew up the
economy," wrote Peter Schiff, CEO of Euro Pacific Capital.
"As someone who bought his first house with a 13%
interest-rate mortgage, I have trouble accepting the idea that
3.25% for 30 years is so high that it is making people hold
back," Tom McClellan, editor of the McClellan Market Report,
wrote. "It's probably something else that is giving consumers
pause."