Fed Fears Hit Mortgage Bonds, Attracting Investors
Mortgage REIT Annaly Capital has raised about $3 billion in recent weeks to buy into the battered mortgage-bond market
By Matt Wirz
The U.S. housing market has seen two years of surging prices./ PHOTO: CHONA KASINGER FOR THE WALL STREET JOURNALA $5.5 trillion bond market supporting the U.S. mortgage industry is being roiled by fears it will be hit in the Federal Reserve’s battle against inflation.
Prices are falling for bonds backed by agency mortgage loans from government-owned lenders Fannie Mae and Freddie Mac.
That is primarily because the Fed has started raising interest rates, which hits the value of all existing fixed-rate bonds, but also because it might start selling some of its $2.7 trillion holdings of the bonds, potentially further diminishing their value.
Analysts worry that Fed sales of existing bonds could flood the market, driving down prices and pushing yields higher as bond investors demand more compensation to lend money.
That would boost mortgage rates because bond yields act as benchmarks for real-estate lenders.
Rising rates over time tend to cool the housing market, which after two years of surging prices has widely been described as overheated.
Most analysts don’t expect the Fed to start selling until next year, but Ankur Mehta, the head of mortgage-backed bond research at Citigroup Inc., predicts the sales to start in the fourth quarter.
The Fed is also planning to reduce its holdings of Treasurys and will need to shed agency bonds to avoid being overexposed to mortgages, he said in a recent report.
Some investors who specialize in the normally placid agency market are raising new funds to buy up bonds on the cheap.
One bargain hunter is Annaly Capital Management Inc. , a real-estate investment trust that invests in mortgage-backed bonds.
The firm agreed to sell its corporate lending platform to Ares Management Corp. for $2.4 billion in April and issued about $750 million of new stock with a plan to go shopping for mortgage bonds.
“It is all about the relative value proposition,” said David Finkelstein, chief executive of Annaly, which uses borrowed funds to boost returns on its investments.
Purchases of agency bonds at current prices are likely to yield annualized returns of 12% to 15%, up from around 10% at the end of 2021, he said.
The additional yield over Treasurys, or spread, that investors demand to buy agency debt swelled to about 1.20 percentage points from 0.70 at the start of the year, said Eric Hagen, an analyst at brokerage BTIG who has a “neutral” recommendation on Annaly stock.
“Sales from the Fed’s portfolio are not something that should be ruled out,” Mr. Hagen said.
“It’s logical they might go down that path because prepayments from the current portfolio are going to be painfully slow.”
With the average 30-year mortgage rate rising to 5%, homeownership might now be out of reach for millions more Americans.
The Fed ended its bond purchases in March and has been reinvesting the proceeds of maturing bonds into new securities.
Starting in June, it will allow $17.5 billion in securities to mature every month without reinvesting proceeds, allowing those bonds to run off passively.
It will allow up to $35 billion in securities to run off every month beginning in September.
The primary purpose of potential sales would be to decrease the share of mortgage bonds held by the Fed, New York Federal Reserve President John Williams said at a conference in May.
With mortgage rates rising rapidly, few borrowers are looking to refinance existing loans, squeezing many mortgage lenders and making $35 billion of monthly runoffs unlikely.
Former Boston Fed President Eric Rosengren has said the central bank could ultimately consider setting a floor for any redemptions; for example, a floor of $20 billion in monthly redemptions would call for $5 billion in active sales following a month in which just $15 billion rolled off the portfolio through passive runoff.
The Fed began buying agency bonds in 2009 to inject liquidity into faltering debt markets, then again in 2012 as part of an economic stimulus program.
Its pandemic-era buying program roughly doubled the central bank’s mortgage holdings in two years.
The Fed would aim to unload just enough to tap the brakes on the economy without causing it to stall out, investors said.
That will be a delicate operation, and the Fed will likely take its time to communicate any plan to sell mortgage bonds before doing so, said Peter Federico, chief executive of AGNC Investment Corp. , a REIT that specializes in agency bonds.
That makes any change this year unlikely, he said.
Higher agency-bond yields hurt the firm at first but are now starting to help.
AGNC’s stock lost about a quarter of its value in the first four months of the year as Treasury and mortgage rates rose alongside short-term interest rates.
The shares gained about 11% in May despite a broad equity selloff.
“The agency market is unique because it plays a role in monetary policy and it often leads the reaction to monetary policy,” Mr. Federico said.
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