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TCW in Mortgage Reversal as Fighting Fed Futile: Credit Markets

November 29, 2012

TCW in Mortgage Reversal as Fighting Fed Futile

A woman walks past the Marriner S. Eccles Federal Reserve building in Washington, D.C., U.S. Photographer: Andrew Harrer/Bloomberg

TCW Group Inc. and Bank of New York Mellon Corp.’s Standish unit say it’s time to stop betting against the Federal Reserve.

The firms are buying government-backed mortgage bonds after reducing their holdings as the debt initially rallied following the Fed’s Sept. 13 announcement that it would purchase $40 billion more of the securities each month. While the move paid off as the bonds reversed course and slumped, the investors say sustained weakness is unlikely as the Fed seeks to boost the economy through its unprecedented stimulus measures.

“The Fed’s activities will win the day in the end,” Bryan Whalen, co-head of mortgage bonds at Los Angeles-based TCW, said in a telephone interview. As the gap between yields on Treasuries and the type of mortgage bonds the central bank is buying reached a record low in September, TCW stopped wagering that the spread would narrow. The firm, which oversees $135 billion, has since changed its position to a “slight overweight.”

The difference in yields between the Fannie Mae securities and the average of those for five- and 10-year Treasuries shrank to an all-time low of 55 basis points following the Fed’s announcement, before expanding to 110 basis points Nov. 14, data compiled by Bloomberg show. The spread closed at 104 yesterday.

‘Large Effect’

Even after relative yields retraced most of the decline this month, Simon Potter, the Federal Reserve Bank of New York’s markets group chief, said Nov. 27 the central bank’s third round of so-called quantitative easing has had a “large effect” on mortgage bonds and has pushed down home-loan rates.

The average rate on a typical 30-year fixed mortgage fell to a record low 3.31 percent in the week ended Nov. 22, down from 3.55 percent in early September, according to Freddie Mac.

JPMorgan Chase & Co. analysts recommended in an outlook report for 2013 that investors should be “ringing in the New Year with an overweight position” on the debt the Fed’s buying while Barclays Plc said the purchases would “overwhelm all other factors.”

“We have been re-engaging at the wider yields,” both because the Fed’s actions are a “very supportive dynamic” and because generally low bond rates create “demand for an asset that’s going to yield more than Treasuries and yet maintain a high quality,” Robert Bayston, managing director of interest rate strategies at Boston-based Standish, said in a telephone interview. The firm oversees $104 billion of fixed-income assets.

Costco, Chavez

Elsewhere in credit markets, Costco Wholesale Corp. sold $3.5 billion of debt as it prepared to pay a special shareholder dividend. Venezuelan government bonds were raised to the equivalent of “buy” by Bank of America Corp. as President Hugo Chavez sought more cancer treatment in Cuba, spurring speculation the government may change. Tommy Hilfiger brand owner PVH Corp. is said to have set the interest rate on $3.83 billion of loans to back its purchase of Warnaco Group Inc.

A credit-default swaps benchmark used to hedge against losses or to speculate on corporate creditworthiness in the U.S. fell for the first time in three days. The Markit CDX North American Investment-Grade index declined 1.2 basis points to 100.9 basis points, according to prices compiled by Bloomberg. It reached 111.4 on Nov. 15, the highest level since July 25.

Stress Gauge

The Markit iTraxx Europe Index of 125 companies with investment-grade ratings dropped 2.6 to 122.5 at 11:45 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan decreased 1 to 112.

The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million.

The U.S. two-year interest-rate swap spread, a measure of stress in credit markets, decreased a second day, narrowing 1 basis point to 11.5 basis points. The measure tightens when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

Bonds of Walt Disney Co. were the most actively traded dollar-denominated corporate securities by dealers yesterday, the day after it raised $3 billion, with 174 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The debt of Caracas-based Petroleos de Venezuela SA, or PDVSA, was fourth-most active after Chavez sought treatment in Havana four months after saying he was “totally free” of cancer.

Regime Prospects

The president’s illness raises the prospects of a new regime that may end policies such as nationalizations and currency controls, Francisco Rodriguez, a Bank of America economist, wrote in a research note to clients. He also said bonds would benefit from a currency devaluation and reduced issuance.

PDVSA’s $6.15 billion of 8.5 percent bonds due in November 2017 held at about the highest since they were issued in 2010 after gaining 1.9 cents to 94.6 cents on the dollar Nov. 27 to yield 9.9 percent, Trace data show.

Costco, in its first offering in almost six years, sold $1.2 billion of 0.65 percent, three-year notes to yield 35 basis points more than similar-maturity Treasuries, $1.1 billion of 1.125 percent, five-year securities at a 50 basis-point spread and $1.2 billion of 1.7 percent, seven-year bonds at 70, Bloomberg-compiled data show.

PVH Loans

The Issaquah, Washington-based company is planning to pay a special dividend of about $3 billion to shareholders before pending tax increases in 2013.

PVH’s financing includes a $1.88 billion seven-year term loan B that will pay interest at 2.75 percentage points to 3 percentage points more than the London interbank offered rate, according to a person with knowledge of the transaction who asked not to be identified because the information is private. Libor, a rate banks say they can borrow in dollars from each other, will have a 75 basis point floor.

PVH is proposing to sell the debt at 99.5 cents on the dollar, the person said, reducing proceeds for the company and boosting the yield to investors.

The rates on a $1.2 billion five-year term loan A portion and a $750 million five-year revolving line of credit will be tied to a leveraged based grid and will pay interest at 1.5 percentage points to 2.25 percentage points more than Libor, the person said. Pricing is set to open at 2 percentage points more than Libor.

Expanded Stimulus

In emerging markets, spreads narrowed 2 basis point to 289 basis points, or 2.89 percentage points, JPMorgan’s EMBI Global index shows. The measure has climbed from 269.7 basis points on Oct. 18, the least since February 2011.

In the U.S. mortgage-bond market, the Fed’s buying is targeting the $5.2 trillion of debt guaranteed by government- supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae. It focuses on 30-year securities trading closest to face value, called current-coupon bonds, because lenders package most new home loans into those notes.

The Fed’s QE3 purchases add to a program started 13 months ago in which it reinvests the proceeds from debt acquired under previous initiatives, including $1.25 trillion of mortgage-bond buying ended in March 2010. That lifts its total purchases each month to about $70 billion.

Investors Overweight

The buying failed to prevent a sell-off that pushed relative yields to within 4 basis points of where they were before the QE3 announcement. The gap between yields on Fannie Mae’s 30-year current-coupon securities and the average of rates on five- and 10-year Treasuries ended last year at 152.

With the outstanding amount of fixed-rate agency mortgage securities set to fall by $75 billion next year, money managers will need to be convinced to sell holdings to give the Fed enough to buy, JPMorgan analysts led by Matt Jozoff wrote in a Nov. 21 report.

About half of money managers are currently “overweight” mortgage bonds, or holding more than found in benchmark indexes, according to surveys by the bank. That’s down by 10 percentage points from before QE3, the analysts said.

The widening of current-coupon spreads earlier this month partly reflected concern that homeowner refinancing will increase as lenders add staff while low mortgage rates persist, and as a second Obama administration looks to aid borrowers, said Ajay Rajadhyaksha, Barclays’s New York-based head of rates and securitized research.

Operation Twist

Investors who buy mortgage bonds trading for more than 100 cents on the dollar face lower returns when principal is repaid faster at par. More homeowners replacing higher-rate notes also fuels greater issuance of low-coupon securities.

Investors have also been speculating the Fed will extend its Treasury purchases after the end of its so-called Operation Twist program, bolstering their relative demand, Rajadhyaksha said in an interview. Even with spreads on low-coupon mortgage bonds tighter than historical levels amid the Fed’s purchases, the debt is attractive based on low benchmark yields and suppressed volatility, he said.

“We’re in unprecedented territory and will be for a while,” he said. “As we settle back into this ‘low for long’ range, we would be long agency MBS.”

The supply of new mortgage bonds also jumped this month as lenders rushed to create securities before Fannie Mae and Freddie Mac begin on Dec. 1 to charge more for their guarantees, according to Bank of America analyst Satish Mansukhani. At the same time, a slump in the shares of real-estate investment trusts (BBREMTG:US) that buy mortgage debt fueled concern they would sell holdings to repurchase stock, he said in a Nov. 16 report.

Fiscal Cliff

The JPMorgan analysts cited challenges including concern over the so-called fiscal cliff of tax increases and spending cuts set to take effect next year, which has driven spreads wider on competing investments such as high-grade corporate bonds. “Once the market gets through these year-end pressures, we believe mortgages are well positioned for outperformance,” they said.

James Camp, managing director of fixed income at Eagle Asset Management Inc., said he’s continued to favor agency mortgage securities because corporate spreads are still too tight as companies take “non-bondholder-friendly” steps such as stock buybacks, and as Europe’s debt crisis wears on.

While Camp views “QE3 skeptically in terms of the real impact” on the economy, “we’re not fighting the trade” of thinking it will drive spreads tighter, he said in a telephone interview from St. Petersburg, Florida.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net


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