Mortgage Bonds Go Global, End 2004 on High Note
Wed Dec 29, 2004 01:30 PM ET
By Julie Haviv
NEW YORK (Reuters) - U.S. mortgage-backed securities enjoyed a banner year in 2004, garnering their strongest gains versus U.S. Treasuries in two years.
While lack of supply and low interest rate volatility certainly worked in the sector's favor, it was the insatiable appetite of foreign investors for the bonds that changed the landscape of the world's largest fixed income market.
"Make no bones about it, mortgages really went global in 2004," said Arthur Frank, director of MBS research at Nomura Securities International. "Overseas investors had dollars to put to work and MBS were their vehicle of choice, offering them an attractive pick-up in yield over Treasuries."
The market for fixed rate agency MBS, which are mortgage bonds backed by Fannie Mae and Freddie Mac, put in a solid total return performance in the first 11 months of 2004. They outperformed comparable duration Treasury bonds by about 1.25 percentage points, providing a total return during the period of approximately 4 percentage points, Frank said.
That is in stark contrast to 2003, when rapid mortgage prepayments and a deluge of supply caused MBS to underperform Treasuries by about 0.35 percentage point, he said.
"Foreign demand has certainly climbed over the years, but it picked up rapidly this year," said Frank.
Net foreign purchases of MBS were $242 billion in mid-2004, up $19 billion from year-end 2003 and $35 billion more than 2002, according to Inside MBS & ABS, a publication of Inside Mortgage Finance. While data is not available yet for the second half of 2004, most analysts believe foreign investment in MBS gained even more momentum during that period.
The strong performance of the $4.5 trillion MBS market in 2004 can partly be attributed to buying from Asian portfolios and China's central bank in particular, according to Steven Abrahams, fixed income mortgage strategist at Bear Stearns.
"U.S. dollar portfolios in Asia have made themselves felt this year in the U.S. rates markets, and perhaps in no sector more than MBS," he said in recent research.
The Chinese central bank's demand for mortgages is partly due to the climbing balance of dollars it has for investment. China's reserves for the year ending in August grew by $131 billion, second only to Japan's $272 billion increase, according to the International Monetary Fund. China's reserves now stand at around $501 billion, while Japan's are at $827 billion.
"For the MBS market, the foreign purchases are relatively a new phenomenon," said David Montano, head of MBS strategy at JP Morgan. He noted that overseas buying has historically been almost exclusively concentrated in U.S. Treasuries and agency debentures.
Net purchases of Treasuries dominated China's activity in the early to mid-1990s, but beginning in 1998, purchases of agency debentures and MBS picked up and moved ahead of Treasuries.
This year's move into MBS came as agency issuance slowed and concern emerged across Asia about agency debt after Fannie Mae's regulator, the Office of Federal Housing Enterprise Oversight, accused the housing giant of using improper accounting in September.
While U.S. Treasury data does not separate MBS investments from agency debentures, "it makes sense that China might lean away from agency debt and into the size, credit, spread and liquidity of (mortgage) pass-throughs," Bear Stearn's Abrahams said.
Too much overseas demand, however, is not necessarily a good thing for the MBS market.
If the United States continues to buy more from China than it sells, China will continue to accumulate dollars. That, coupled with slowing agency issuance, could tighten MBS spreads from their current levels in 2005, analysts said.
"The sobering possibility is that China could keep buying MBS right up until spreads to Treasuries no longer compensate for any differences in credit or liquidity," said Abrahams.
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