Bond traders not drinking Yellen Kool-Aid

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For evidence that U.S. bond investors aren’t being satisfied by Federal Reserve Chair Janet Yellen’s dovish words, take a look at government-backed mortgage securities.

In a market dominated by 30-year loans, buyers from banks to real estate investment trusts have piled into debt tied to 15-year mortgages offering greater protection against rising interest rates. More demand for the shorter-term debt caused yields in the securities to evaporate, with one measure of spreads over Treasuries narrowing to just 0.02 percentage point last month from more than 0.4 about a year ago.

While bond bears were pushed to capitulate across fixed-income markets as yields defied forecasts and declined this year, some investors are still looking for safety. For those willing to sacrifice returns, 15-year securities offer banks and REITs in the $5.4 trillion mortgage-bond market a way to hedge some of their risks while sticking with the debt, according to Brean Capital LLC’s Scott Buchta.

“It’s one of those things where these guys are investing defensively,” said Buchta, the head of fixed-income strategy at the New York-based brokerage. “You’re not trying to kill it, you’re trying not to be killed if things go the other way.”

Dovish Fed

Yellen reiterated to lawmakers yesterday that “a high degree of monetary policy accommodation remains appropriate” to combat persistent weakness in the nation’s economy. The central bank’s target for short-term rates -- held at almost zero since December 2008 -- is likely to stay low for a “considerable period” after the Fed ends its unprecedented bond purchases as soon as October. The U.S. Treasury 10-year yield rose 0.01 percentage point to 2.56 percent at 8:52 a.m. in New York, according to Bloomberg Bond Trader data.

Shorter maturities on 15-year mortgage bonds and faster repayment of principal than 30-year debt mean they’ll slump less if long-term yields climb. There’s also less risk that the notes remain outstanding longer than investors anticipate if higher borrowing costs curb refinancings and home sales.

Even as bond managers have taken on more risk as 2014 progressed, they’re still looking to shield against rising yields that can lead to losses on fixed-income securities.

In January, the duration of their holdings, a measure of risk that is partly tied to the length of maturities, fell the most below their stated targets in years, according to surveys by Stone & McCarthy Research Associates. While not as bearish, fund managers were still positioned below their targets in the Princeton, New Jersey-based research firm’s July 8 poll.

Cushioning blows

While 15-year mortgage securities look too expensive to most investors, the rate protection is more important to certain types of buyers, said Jason Callan, Columbia Management Investment Advisers LLC’s structured-products head.

“There’s been significant demand from the REITs, so it makes sense why valuations are where they are,” said Callan, who oversees about $17 billion in mortgage-related assets from Minneapolis.   Banks are being lured to the shorter debt in part because tougher capital rules have left them with even more incentive to avoid paper losses on bond holdings, Buchta said. With increasing deposits and limited loan growth, commercial banks still boosted their agency mortgage-bond holdings by about $35 billion in the first half of this year to $1.35 trillion, Fed data show.

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