Falling yields rock U.S. mortgage bond market

By Richard Leong

(Reuters) - The massive U.S. bond market rally has not been a boon for all types of fixed-income securities.

Some $8.4 trillion in mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae have been rocked by the swift decline in bond yields on worries that a wave of mortgage refinancing would erode the value of these bonds.

In the first four trading days in August, MBS have only managed 0.46% in total return, while all U.S. investment-grade bonds have already delivered a 1.27% gain, according to indexes compiled by Bloomberg and Barclays (LON:BARC).

"This is not a good look for mortgages," said Walt Schmidt, senior vice president and manager of the mortgage strategies group at FTN Financial.

While they offer higher yields than Treasuries, MBS are "negatively convexed," which means their prices fall when bond yields fall or rise quickly.

Treasury yields have tumbled since last week in the wake of the escalation in trade tensions between China and the United States. U.S. benchmark 10-year Treasury note yields (US10YT=RR) have fallen 0.30 percentage point in a week.

Last Thursday, U.S. President Donald Trump vowed to impose a 10% tariff on $300 billion worth of Chinese imports in a bid to pressure Beijing for a trade deal.

China retaliated on Monday by letting its currency weaken to 7 yuan to the dollar, a level not seen in a decade. This led to the U.S. Treasury Department to label China as a currency manipulator.

Anxiety about a flood of refinancing was stoked by data released by the Mortgage Bankers Association on Wednesday that showed loan applications for home refinancing hitting their highest level since November 2006 as some 30-year home borrowing costs fell to their lowest levels in the same time frame.

"We fully expect that refinance volume will jump even higher this week given the further drop in rates," Mike Fratantoni, MBA's chief economist said.

More refinancing reduces the values of MBS because their holders are paid back earlier than they had expected and would have to reinvest their money at lower yields.

Data released on Wednesday showed MBS prepayments sped up in July from a pickup in refinancing due to falling mortgage rates, analysts said.

The deep decline in Treasury yields has led to some buying of Treasuries and increased receiving in the interest rate swaps on Wednesday by mortgage servicers and investors in a bid to offset the expected drop in income on their MBS holdings, analysts said.

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