Bond traders not drinking Yellen Kool-Aid

REIT demand

REITs that invest in mortgages shifted more into safer 15-year debt after their shares were rocked last year by the debt slump that followed the Fed’s signals it was approaching the start of a tapering of its then-$85 billion in monthly bond buying. They lost 20.7 percent in the four months ended August 2013, assuming reinvested dividends, a Bloomberg index shows. They’ve since gained almost 22 percent as bond appreciated.

At American Capital Agency Corp., the second-largest mortgage REIT, 15-year securities jumped to 48 percent, or $34 billion, of its investments as of March 31, according to company presentations. That’s up from 22 percent, or $22.6 billion, a year earlier.

The increase mainly occurred in the second quarter of last year, with the Bethesda, Maryland-based firm reducing the holdings this year, President Gary Kain said in an e-mail. “Many people seem to attribute the strength of 15s to us despite the fact we were net sellers,” he wrote, saying he couldn’t comment further before his company’s quarterly earnings.

Risk trade-off

Kain said during a presentation last month that he still believed yields will rise and spreads will widen over time. The shorter securities offer good protection against that with principal that comes back more quickly, he said.

The safety is coming with a cost. Thirty-year mortgage securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae have gained 3.9 percent this year after losing 1.6 percent on average last year, according to Bank of America Merrill Lynch index data. Fifteen-year debt, which fell just 0.92 percent in 2013, has underperformed this year with a 2.5 percent gain.

For 30-year securities, a measure of relative yields known as option-adjusted spreads, which takes into account expected rate volatility, narrowed to 0.29 percentage point, from 0.6 percentage point a year ago, the data show. Fifteen-year bond spreads fell to 0.02 percentage point on June 23 before widening to 0.11 percentage point.

‘Extreme side’

Not all mortgage REITs piled into 15-year securities. The debt accounted for just 11.4 percent of Annaly Capital Management Inc.’s $65.3 billion in fixed-rate agency mortgage holdings on March 31, according to a company presentation.

“The valuations are on the extreme side,” David Finkelstein, head of agency mortgage trading at New York-based Annaly, the largest mortgage REIT, said last month in a telephone interview.

Fifteen-year mortgages have become rarer because they are typically used more during periods of high refinancing, as borrowers seek to shorten or maintain the length of their debt.

As higher rates reduced refinancing, issuance of 15-year Fannie Mae and Freddie Mac bonds fell 69 percent to $43.5 billion in the first half of 2014 from a year earlier, compared with a 56 percent drop to $183.6 billion for 30-year securities, according to Bank of America data. The amount of conventional 15-year debt outstanding dropped $15.5 billion, while the 30- year market grew $12.3 billion.

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