The Tell: Mortgage bonds are cheap but ‘no one is buying,’ says BofA Global

A backdrop of uncertainty unleashed this year by the Federal Reserve’s campaign to fight inflation through dramatically higher interest rates has resulted in a sputtering housing market. It’s also left those who invest in the bonds used to finance much of the estimated $44 trillion housing market sitting on their hands.

The pause from many bond buyers comes despite an overwhelming majority of investors, pegged at nearly 90% in a November BofA Global survey, indicating that government-backed mortgage bonds were undervalued (see chart) when compared with U.S. Treasurys, high-grade corporate credit and other assets.

The yield on the 10-year Treasury
TMUBMUSD10Y,
3.492%
rate was near 3.4% Wednesday, about its lowest in three months, while its counterpart for U.S. investment-grade corporate bonds was roughly 5.3%.

But the “agency” market for government-guaranteed mortgage bonds is “cheap, no one is buying,” the BofA strategy team, including Jeana Curro, Chris Flanagan and Ge Chu, wrote in their outlook.

“Uncertainty for most of 2022 has resulted in crisis-level market volatility, which has sidelined many traditional buyers and necessitated the constant reevaluation of rate and spread forecasts,” they said. “We remain optimistic, but cautious as we await clarity,” around the Fed’s path on interest rates, which should “eventually” emerge in 2023.

Fed footprint shrinks as housing market stumbles

While housing prices have begun to fall by double digits from peak pandemic levels in some West Coast areas, a huge swath of U.S. homeowners have already refinanced in recent years, locking in historically low rates.

Still, the transition away from cheap debt hasn’t been painless. The Fed has been ratcheting up borrowing costs in an effort to pull down high inflation, with one ripple effect being the 30-year fixed-mortgage rate shooting above 7% in November, a 20-year high, while an affordability crisis has stunted home sales.

Cracks also have emerged recently in riskier parts of U.S. housing credit, including the collapse of home lender Reverse Mortgage Investment Trust Inc. in November, the year’s biggest bankruptcy so far, according to S&P Global Market Intelligence.

Even so, the Fed next week is expected to raise its policy rate by another 50 basis points, bringing it to a range of 4.25% to 4.5%. BofA economists expect the Fed’s benchmark rate to hit a “terminal,” or peak, rate for this cycle at 5% to 5.25% in the first quarter of next year.

Bond funds have been hit hard, with many suffering outflows and continued investor skittishness about whether the Fed’s most aggressive pace of monetary tightening in 40 years might land the U.S. economy in the ditch.

The total return on the ICE BofA US Mortgage Backed Securities index was pegged at negative-11% for the year so far, according to FactSet data, versus a minus-12% return for the benchmark Bloomberg US Aggregate index. Individuals often gain exposure to home mortgages in bond funds and through exchange-traded funds like the iShares MBS ETF
MBB,
-0.47%,
which was down 11.5% year to date Wednesday, according to FactSet.

The S&P 500 index
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+0.25%
has tumbled 17.5% on the year, despite a recent rally for stocks on hopes that the Fed might start soon raising rates less aggressively, while the Dow Jones Industrial Average
DJIA,
+0.47%
is still 5.9% lower since January.

But beyond higher rates, the Fed also has been shrinking its massive balance sheet, a process called quantitative tightening (QT), by letting some of its nearly $2.7 trillion pile of mortgage bonds and Treasury holdings roll off each month as the debt matures. That’s sparked concern about who might step in to fill the void.

Related: Fed’s shrinking of balance sheet via quantitative tightening is ‘a complete mistake,’ says Mizuho

“With the Fed’s long awaited initiation of QT this past June, the Agency MBS market has had to confront the fact that for the first time really this century, there is no government buyer of last resort,” the BofA team wrote.