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Home loan rates stay low, historically, but will mortgage-bond investors want better returns?

Thursday was Day One of the mortgage market’s new life without Federal Reserve assistance. And as was widely expected, the market stood on its own two feet.

Benchmark yields on mortgage-backed securities issued and guaranteed by Fannie Mae and Freddie Mac inched up to three-month highs, but they already were on their way there over the last week, tracking a jump in long-term Treasury bond yields.

The yield on 30-year Freddie Mac mortgage bonds finished at 4.58%, up from 4.53% on Wednesday and the highest since Dec. 31.

The yields that investors demand on Fannie and Freddie mortgage bonds help determine what lenders charge for home loans because so many of their loans now are sold to those government-controlled agencies.

Fedfacade2 The Fed on Wednesday completed its 16-month-old program of buying $1.25 trillion of Fannie and Freddie mortgage bonds. The central bank launched the purchases in the depths of the credit crisis, aiming to provide funding to the mortgage market in the hope of keeping home loan rates as low as possible.

Mission accomplished: What the Fed’s purchases did was sharply narrow the “spread” between yields on mortgage-backed bonds and yields on Treasury bonds.

Just before the Fed’s purchase program was announced in November 2008 the yield on Freddie Mac bonds was 5.53% and the yield on 10-year Treasury notes was 3.33%, which meant the spread was 2.2 percentage points.

On Thursday, with the 10-year T-note yield at 3.85%, the Freddie Mac bond yield spread was 0.73 of a point above the T-note.

But with the Fed no longer buying Fannie and Freddie bonds, the question is whether private investors will be willing to take up the slack without demanding higher yields on the bonds.

Many market analysts have opined this week that yield-hungry investors would be ready and willing to buy mortgage securities, particularly relative to lower-yielding Treasuries and given the government's backing of Fannie and Freddie.

Scott Simon, head of mortgage-bond investing at bond fund giant Pimco in Newport Beach, said he doubted that the spread on mortgage securities could rise even 0.20 of a point from current levels before buyers would swarm.

Bryan Whalen, a mortgage-bond investor at TCW Group in L.A., said even a 0.10-of-a-point rise in the spread “would pique our interest.”

Still, even if the spread between mortgage bonds and Treasuries stays where it is, mortgage yields (and thus mortgage rates) would have to rise if Treasury yields rise.

That’s what has been happening lately: Last week Treasury yields jumped after the government’s sale of $118 billion in new debt attracted fewer investors than expected. This week, the average mortgage rate nationwide rose back above 5% for the first time since late February.

Some investors make the case that mortgage-bond spreads should be significantly wider to make the securities attractive.

Tom Atteberry, a bond fund manager at First Pacific Advisors in L.A., notes that if interest rates in general are headed higher as the economy improves, the average maturity of mortgage-backed securities will lengthen --  because fewer homeowners with low-rate loans are likely to prepay them.

The longer a bond’s term, the more its market price reacts to interest rate shifts. That increased volatility risk should make investors demand a higher return on mortgage bonds, Atteberry said.

The historical average spread of mortgage bonds to Treasuries is about 1.25 percentage points. With the Fed now out of the picture, “If that’s what [the spread] was in the past, why not today?” Atteberry wonders.

-- Tom Petruno

Photo: The Fed's headquarters in Washington. Credit: Andrew Harrer / Bloomberg News

 
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