Mortgage Bonds Slump Near Post-Crisis Record

The selloff in government bonds and the Federal Reserve’s tightening message is claiming another victim: the $8 trillion mortgage bond market.

(Bloomberg) — The selloff in government bonds and the Federal Reserve’s tightening message is claiming another victim: the $8 trillion mortgage bond market.

Mortgage-backed securities, which repackage home loans backed by the US government, cheapened to some of the widest levels in history in recent weeks, according to a key measure. The selloff has brought the asset class near the post-financial crisis record reached in May. 

The rout comes as global markets remain on edge after a selloff in government bonds drove long-term borrowing costs in the US and Europe to the highest levels in more than a decade. Both European Central Bank and Fed officials have made it clear they are unlikely to ease monetary policy anytime soon.

Rising spreads on mortgage bonds are on top of the highest 30-year Treasury yields since 2007, and is inflicting pain on investors who bought the securities in hopes that long-term yields had stabilized. Higher mortgage bond yields could also feed into even higher mortgage rates for homebuyers, which last week topped 7.5% for the first time since 2000.

The threat of higher-for-longer interest rates, concern over swelling government deficits and increased bond supply, and a potential government shutdown has spooked investors, sparking volatility. BlackRock Inc. Chief Executive Officer Larry Fink said last week he expects 10-year yields to top 5% as shifts in geopolitics and supply chains make inflation more persistent. 

“It’s basically a capitulation to the higher-for-longer Fed environment,” said Richard Estabrook, an MBS strategist at Oppenheimer & Co. “People were buying mortgage bonds with coupons of 2% and 2.5% with the expectation of lower rates going into late 2023 and 2024, and the market sentiment has turned sharply against that trade.”

Mortgage bonds were trading at a risk premium of about 1.86 percentage points on Tuesday, compared with the post-crisis record of almost 1.93 percentage points in late May. The bonds reached those wides in a matter of days, as they were trading at 1.63% barely two weeks earlier, based on the difference between yields on current coupon mortgages and a blend of five- and 10-year Treasuries. 

For MBS investors, the Fed’s message adds pressure to an already weak market. Surging interest rates, the Fed’s decision to shrink its exposure, and the regional banking crisis that left regulators with about $100 billion of the securities to sell, further dampened demand. That made the bonds look “screaming cheap” earlier this year, with new buyers coming in and scooping up the securities. But that demand has not been enough to return the bonds to its previous tights, as US banks — among the biggest buyers of the debt before — have not come back to buy en masse after slowing purchases in 2022. 

“With the Fed reiterating its intent to keep policy tight until the data turns, not sure what breaks this streak between now and year end,” wrote Erica Adelberg, Bloomberg Intelligence’s MBS strategist, in a note to clients.

(Adds fourth paragraph to detail 30-year Treasury yield and mortgage rates.)

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