Mortgage-Bond Investors Eyeing Hedge Before ‘Pain Trade’ Strikes

(Bloomberg) -- Baron Rothschild famously said “the time to buy is when there’s blood in the streets.” For mortgage-bond investors, that time may be now.

As interest rates reach multiyear highs, mortgage-backed securities traders are taking a hard look at buying protection against the so-called “pain trade” of falling bond yields. The idea is that buying up cheap hedges now will leave investors better prepared for lower rates in the future, when homeowners will be more likely to refinance, shortening the duration of bonds and pushing them to underperform.

“The general view in the market is for a rates increase, but that’s not the main risk. The main risk is the opposite of the consensus view,” Walter Schmidt, head of mortgage-backed securities research at FTN Financial, said in a phone interview. “Given where we are in the market place, the risk that your mortgage bond duration will get shorter is greater than the risk to the bond extending.”

The trade can be done through so-called “specified pools” -- mortgage bonds sorted by borrower characteristics such as credit scores or loan size. These pools, which are considered cheap right now by some, are designed to provide investors with more certainty on how soon the underlying debt will be paid off.

Buying these specified pools can protect from falling rates -- the “pain trade” -- and is a chance to take profit, Schmidt said.

Mortgage-Bond Investors Eyeing Hedge Before ‘Pain Trade’ Strikes

Specified pools are by some measures inexpensive because rising mortgage rates mean about 90 percent of borrowers currently have no incentive to refinance.

A good example are the “low-loan balance specified pools,” which tend to have borrowers that pay back loans at a slower pace during periods of declining rates. Pools of Fannie Mae 30-year loans with 4 percent and 4.5 percent coupons have seen their price, or “payups,” drop about one point year-to-date, according to data compiled by Bloomberg.

“Demand so far has been mostly in traditional loan balance stories,” Matthew Johannes, a director at INTL FCStone Inc., said in an email interview. “To avoid chasing that trade, we see better value in secondary call protection, such as slow servicer pools, which can be bought at minimal payups.”

But when will interest rates start dropping? They just touched a seven-year high. If you listen to HSBC Holdings Plc, the prospect of that happening isn’t far fetched. The bank’s forecast is for 10-year Treasury yields to end this year at 2.80 percent and rally to 2.50 percent by the end of 2019.

“History suggests the near-term focus on a couple of data points will revert to focus on long-term economic fundamentals. These have not changed much at all,” said Lawrence Dyer, head of U.S. rates strategy at the firm, in an email interview. Rather than shy away from duration, he said he sees value in longer maturity Treasuries.

Read More: Increasing Risks Seen in New 30-Year Mortgage Pools: Barclays

With the most recently issued 30-year mortgage bonds trading above par, a rising concern is the quality of borrowers. These are homeowners with the ability to refinance quickly should rates drop enough. “So if you get a rally from here, you are going to have a whole slew of brand new 4 percent and 4.5 percent MBS that are going to refinance very quickly,” said Schmidt.

The government agencies have mostly held the line on expanding credit since the financial crisis hit a decade ago, and now the Federal Reserve is set to exit the mortgage market and no longer absorb the fastest paying pools.

“Investors are seeking alternatives,” Johannes said.

©2018 Bloomberg L.P.