Perfect storm for U.S. mortgage-backed investors

(March 2006) Investors seeking yield were well compensated when interest rates fell; they received capital gains that in many instances gave them better returns than equities. In a rising rate environment, however, income investors find it more difficult to make an adequate return. Not only do rising rates usually result in lower bond valuations, but […]

By Michael Barrett | March 1, 2006 | Last updated on March 1, 2006
7 min read

While some Canadian mutual funds have dabbled in U.S. mortgage-backed securities, Toronto-based Sentry Select Capital Corp. introduced that market to Canadian investors in a big way with launch of Mortgage-Backed Securities Trust in the 2003. Sentry Select has since introduced three other closed-end trusts — including two in 2005 — that also invest in the U.S. MBS market. Claymore Investments entered this sector with its Adjustable Rate MBS Trust in early 2005.

The appeal of the U.S. market was an active repurchase (repo) market, which allowed the mortgage-backed securities to be used as collateral to be borrowed against. This allowed for leverage so that returns could be ratcheted up to appeal to Canadian income investors. The credit risk was nearly negligible, as U.S. mortgage-backed securities issued by government-owned or sponsored Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie Mae) are either explicitly backed by the U.S. government, or treated as if they are.

The returns of each trust would thus be less dependent on the actual return from the mortgage-backed securities. They would play a part, but the trust returns are more dependent on a spread — the difference between the returns of the portfolio’s MBS holdings and the cost of borrowing to invest. Because the portfolios were invested almost exclusively in AAA-rated securities, the borrowing costs were quite low. A spread of 90 basis points, levered 10 times, would be a 9% bonus to a simple mortgage-backed portfolio that might otherwise yield just 3% or 4%.

Because the returns were based in part on a spread in interest rates, these trusts were sold on their ability to deliver consistent returns over a complete interest rate cycle. New York-based Fixed Income Discount Advisory Company (FIDAC) managed the Sentry Select portfolios in a similar manner to its NYSE-listed Annaly Mortgage Management, which had a strong track record.

Market movements in 2005, however, pointed out the limitations of those assumptions. A combination of rising short-term rates and a flattening yield curve led to losses of between 12% and 20% on a net asset value basis for most of the Canadian mortgage-backed trusts. Investors still received regular distribution payments, which cut the losses on a total return basis to the neighbourhood of 8% to 12%.

Losses on a market price basis were more substantial. The two trusts that existed at the start of 2005 traded on the Toronto Stock Exchange at premiums to NAV of 12% and 20% in January 2005. By year’s end, the norm was a discount of 5% to 10%, in line with the discount of many other closed-end trusts.

More important than the paper losses for income investors are the cuts in distributions.

One trust, the original MBS Trust, cut its monthly distributions from 7.5 cents per unit to 6 cents in February, and then to 3.5 cents in December. In late January, the three oldest Sentry Select MBS trusts all reduced distributions, effective Feb. 28, 2006. MBS Trust distributions dropped from 3.5 cents to 2 cents, while MBS Adjustable Rate Income Fund and Sentry Select MBS Adjustable Rate Income Fund II both halved their distributions, from 6 cents to 3 cents per unit.

Over the course of 2005, the U.S. Federal Reserve jacked its key Federal Funds rate from 2.25% to 4.25%. Short-term bond yields moved in line, if not in step. Yields on 10-year treasuries balked however, moving lower through the first half of the year before finally moving up to end the year at 4.39% — just 17 basis points higher than at the start of the year, and actually lower than yields on two-year bonds.

This created a double-whammy for mortgage-backed security funds. The higher short-term rates increased the costs of borrowing. The portfolio’s longer-term mortgage-backed assets, which generally perform similarly to short-term bonds, declined. The result was a severe compression of the spread.

From a historical norm of a 1.20% to 1.40% spread, the spreads were as low as 0.15% in the third quarter, noted MFA Spartan II LLC, portfolio manager of Claymore’s Adjustable Rate MBS Trust in a December portfolio commentary.

In the press release announcing the reduced distributions, FIDAC chairman Mike Farrell specifically fingered the flattened yield curve and compressed spreads that have resulted from the U.S. Federal Reserve’s persistent rate hikes over the past 19 months.

“During the tightening phase of an interest-rate cycle, our cost of financing will rise faster than the yield on our assets,” Farrell said in the release. “Our results will reflect these conditions while they persist through spread compression, which reduces the amount of income available for distribution, and through pressure on asset values.”

Interest rate risk is one of two major risks faced by mortgage-backed security investors. The other major risk is not credit risk, as with other debt issuers, since the mortgage-backed securities in these trusts carry an actual or implied AAA rating. The other major risk is actually prepayment risk. Owners of a mortgage-backed security receive payments of interest and principal as the underlying mortgage loans are paid off. They trade on the market based on assumptions about interest and prepayment rates.

When mortgage rates are believed to be at lows and heading higher, prepayment activity increases. Mortgage owners are eager to pay off older mortgages at higher rates and lock in new mortgages at the lower rates. A surge in prepayments reduces the value of mortgage-backed securities — money repaid is no longer earning interest. Through much of the middle part of 2005, with 10-year bond yields under 4%, and mortgage rates perceived to be heading higher, prepayment activity rapidly increased as home-owners sought to lock in debt at these lower rates. Prepayments continue to be strong even as rates begin to move higher, because there is often a time lag as refinancings are completed. By the end of 2005, however, the prepayment activity waned.

The overall effect was a kind of a perfect storm for mortgage-backed securities. The combination of higher short rates, a flattening yield curve and a surge in prepayments is a virtual worst-case scenario for these assets.

There will no doubt be a reaction by investors to these securities, based on the market price swinging around the net asset value, plus the distribution cuts.

For investors who elect to stay in the sector, it’s not hard to imagine a recovery. Spreads between the security yields and borrowing costs could return to normal levels. In the third quarter of 2000, spreads were compressed to a low of 0.30%, but after the U.S. Federal Reserve stopped raising rates, spreads rebounded and returns on equivalent U.S. products were very strong over 2001 and 2002.

A steeper yield curve will generate more positive results. The prepayment amounts are being reinvested in the new higher rate environment, generating higher levels of income for the securities. The losses in a rising interest rate environment are recorded immediately since investments are “marked to market.” Over time, these losses can be offset by the higher levels of income earned at the higher rates.

Farrell noted that his company’s model often results in troughs in returns near the end of a Fed tightening, and that the prolonged and sizeable tightening has created better value in the market.

Still, income investors will want to see some evidence of a recovery after the distribution cuts. Sentry Select MBS Adjustable Rate Income Fund II (MGS.UN), the largest of the Sentry Select trusts will pay $0.03 per month. With a market price of about $7.70, that’s a yield of about 4.675%. The distributions from this trust, and most of the others in this space, are designed to be taxed at the capital gains rates, thanks to a structure in which the trusts actually own a portfolio of Canadian equities used as collateral by a counterparty to gain exposure to a portfolio of MBS investments. That 4.675% yield has the same after-tax yield as an income investment earning 6.8%.

Michael Barrett is a Toronto-based financial services writer and editor.

(03/03/06)

Michael Barrett

(March 2006) Investors seeking yield were well compensated when interest rates fell; they received capital gains that in many instances gave them better returns than equities. In a rising rate environment, however, income investors find it more difficult to make an adequate return.

Not only do rising rates usually result in lower bond valuations, but they can also impact dividend-paying stocks and many segments of the income trust market.

Still, rising rates do nothing to curb the appetite of income-hungry investors. The search for alternative income investments that could succeed in any interest rate environment has fed investor interest in floating-rate trusts and mortgage-backed securities trusts.

The appeal of the former is more obvious. The periodic reset of floating rate debt coupons makes those investments less dependent on interest rate movements. While rising rates may result in a decline in the value of the bonds, higher coupons could offset this decline.

Between October 2004 and May 2005, three floating-rate trusts were introduced to Canadian investors: one from Fairway Capital, Nuveen Senior Floating Rate Income Fund (FSL.UN) and two from First Trust, Highland Capital Floating Rate (FHT.UN) and a successor (FHM.UN). Through a period of generally higher short-term rates, these trusts all largely maintained their value on a net asset value basis. In each case, market prices have dropped as investors have digested issue costs and set each trust’s price at a typical discount to NAV.

The downside to floating rate issues is that their returns aren’t very spectacular.

Mortgage-backed investments have had a different ride. They have been part of Canadian portfolios since the Canada Mortgage and Housing Corporation first issued mortgage-backed securities in the 1980s. By now, most investors are aware of the basics of MBS investing, how mortgages are “pooled” and how investors gain an ownership interest in that pool, receiving interest and principal payments associated with the underlying mortgages.

While some Canadian mutual funds have dabbled in U.S. mortgage-backed securities, Toronto-based Sentry Select Capital Corp. introduced that market to Canadian investors in a big way with launch of Mortgage-Backed Securities Trust in the 2003. Sentry Select has since introduced three other closed-end trusts — including two in 2005 — that also invest in the U.S. MBS market. Claymore Investments entered this sector with its Adjustable Rate MBS Trust in early 2005.

The appeal of the U.S. market was an active repurchase (repo) market, which allowed the mortgage-backed securities to be used as collateral to be borrowed against. This allowed for leverage so that returns could be ratcheted up to appeal to Canadian income investors. The credit risk was nearly negligible, as U.S. mortgage-backed securities issued by government-owned or sponsored Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie Mae) are either explicitly backed by the U.S. government, or treated as if they are.

The returns of each trust would thus be less dependent on the actual return from the mortgage-backed securities. They would play a part, but the trust returns are more dependent on a spread — the difference between the returns of the portfolio’s MBS holdings and the cost of borrowing to invest. Because the portfolios were invested almost exclusively in AAA-rated securities, the borrowing costs were quite low. A spread of 90 basis points, levered 10 times, would be a 9% bonus to a simple mortgage-backed portfolio that might otherwise yield just 3% or 4%.

Because the returns were based in part on a spread in interest rates, these trusts were sold on their ability to deliver consistent returns over a complete interest rate cycle. New York-based Fixed Income Discount Advisory Company (FIDAC) managed the Sentry Select portfolios in a similar manner to its NYSE-listed Annaly Mortgage Management, which had a strong track record.

Market movements in 2005, however, pointed out the limitations of those assumptions. A combination of rising short-term rates and a flattening yield curve led to losses of between 12% and 20% on a net asset value basis for most of the Canadian mortgage-backed trusts. Investors still received regular distribution payments, which cut the losses on a total return basis to the neighbourhood of 8% to 12%.

Losses on a market price basis were more substantial. The two trusts that existed at the start of 2005 traded on the Toronto Stock Exchange at premiums to NAV of 12% and 20% in January 2005. By year’s end, the norm was a discount of 5% to 10%, in line with the discount of many other closed-end trusts.

More important than the paper losses for income investors are the cuts in distributions.

One trust, the original MBS Trust, cut its monthly distributions from 7.5 cents per unit to 6 cents in February, and then to 3.5 cents in December. In late January, the three oldest Sentry Select MBS trusts all reduced distributions, effective Feb. 28, 2006. MBS Trust distributions dropped from 3.5 cents to 2 cents, while MBS Adjustable Rate Income Fund and Sentry Select MBS Adjustable Rate Income Fund II both halved their distributions, from 6 cents to 3 cents per unit.

Over the course of 2005, the U.S. Federal Reserve jacked its key Federal Funds rate from 2.25% to 4.25%. Short-term bond yields moved in line, if not in step. Yields on 10-year treasuries balked however, moving lower through the first half of the year before finally moving up to end the year at 4.39% — just 17 basis points higher than at the start of the year, and actually lower than yields on two-year bonds.

This created a double-whammy for mortgage-backed security funds. The higher short-term rates increased the costs of borrowing. The portfolio’s longer-term mortgage-backed assets, which generally perform similarly to short-term bonds, declined. The result was a severe compression of the spread.

From a historical norm of a 1.20% to 1.40% spread, the spreads were as low as 0.15% in the third quarter, noted MFA Spartan II LLC, portfolio manager of Claymore’s Adjustable Rate MBS Trust in a December portfolio commentary.

In the press release announcing the reduced distributions, FIDAC chairman Mike Farrell specifically fingered the flattened yield curve and compressed spreads that have resulted from the U.S. Federal Reserve’s persistent rate hikes over the past 19 months.

“During the tightening phase of an interest-rate cycle, our cost of financing will rise faster than the yield on our assets,” Farrell said in the release. “Our results will reflect these conditions while they persist through spread compression, which reduces the amount of income available for distribution, and through pressure on asset values.”

Interest rate risk is one of two major risks faced by mortgage-backed security investors. The other major risk is not credit risk, as with other debt issuers, since the mortgage-backed securities in these trusts carry an actual or implied AAA rating. The other major risk is actually prepayment risk. Owners of a mortgage-backed security receive payments of interest and principal as the underlying mortgage loans are paid off. They trade on the market based on assumptions about interest and prepayment rates.

When mortgage rates are believed to be at lows and heading higher, prepayment activity increases. Mortgage owners are eager to pay off older mortgages at higher rates and lock in new mortgages at the lower rates. A surge in prepayments reduces the value of mortgage-backed securities — money repaid is no longer earning interest. Through much of the middle part of 2005, with 10-year bond yields under 4%, and mortgage rates perceived to be heading higher, prepayment activity rapidly increased as home-owners sought to lock in debt at these lower rates. Prepayments continue to be strong even as rates begin to move higher, because there is often a time lag as refinancings are completed. By the end of 2005, however, the prepayment activity waned.

The overall effect was a kind of a perfect storm for mortgage-backed securities. The combination of higher short rates, a flattening yield curve and a surge in prepayments is a virtual worst-case scenario for these assets.

There will no doubt be a reaction by investors to these securities, based on the market price swinging around the net asset value, plus the distribution cuts.

For investors who elect to stay in the sector, it’s not hard to imagine a recovery. Spreads between the security yields and borrowing costs could return to normal levels. In the third quarter of 2000, spreads were compressed to a low of 0.30%, but after the U.S. Federal Reserve stopped raising rates, spreads rebounded and returns on equivalent U.S. products were very strong over 2001 and 2002.

A steeper yield curve will generate more positive results. The prepayment amounts are being reinvested in the new higher rate environment, generating higher levels of income for the securities. The losses in a rising interest rate environment are recorded immediately since investments are “marked to market.” Over time, these losses can be offset by the higher levels of income earned at the higher rates.

Farrell noted that his company’s model often results in troughs in returns near the end of a Fed tightening, and that the prolonged and sizeable tightening has created better value in the market.

Still, income investors will want to see some evidence of a recovery after the distribution cuts. Sentry Select MBS Adjustable Rate Income Fund II (MGS.UN), the largest of the Sentry Select trusts will pay $0.03 per month. With a market price of about $7.70, that’s a yield of about 4.675%. The distributions from this trust, and most of the others in this space, are designed to be taxed at the capital gains rates, thanks to a structure in which the trusts actually own a portfolio of Canadian equities used as collateral by a counterparty to gain exposure to a portfolio of MBS investments. That 4.675% yield has the same after-tax yield as an income investment earning 6.8%.

Michael Barrett is a Toronto-based financial services writer and editor.

(03/03/06)

(March 2006) Investors seeking yield were well compensated when interest rates fell; they received capital gains that in many instances gave them better returns than equities. In a rising rate environment, however, income investors find it more difficult to make an adequate return.

Not only do rising rates usually result in lower bond valuations, but they can also impact dividend-paying stocks and many segments of the income trust market.

Still, rising rates do nothing to curb the appetite of income-hungry investors. The search for alternative income investments that could succeed in any interest rate environment has fed investor interest in floating-rate trusts and mortgage-backed securities trusts.

The appeal of the former is more obvious. The periodic reset of floating rate debt coupons makes those investments less dependent on interest rate movements. While rising rates may result in a decline in the value of the bonds, higher coupons could offset this decline.

Between October 2004 and May 2005, three floating-rate trusts were introduced to Canadian investors: one from Fairway Capital, Nuveen Senior Floating Rate Income Fund (FSL.UN) and two from First Trust, Highland Capital Floating Rate (FHT.UN) and a successor (FHM.UN). Through a period of generally higher short-term rates, these trusts all largely maintained their value on a net asset value basis. In each case, market prices have dropped as investors have digested issue costs and set each trust’s price at a typical discount to NAV.

The downside to floating rate issues is that their returns aren’t very spectacular.

Mortgage-backed investments have had a different ride. They have been part of Canadian portfolios since the Canada Mortgage and Housing Corporation first issued mortgage-backed securities in the 1980s. By now, most investors are aware of the basics of MBS investing, how mortgages are “pooled” and how investors gain an ownership interest in that pool, receiving interest and principal payments associated with the underlying mortgages.

While some Canadian mutual funds have dabbled in U.S. mortgage-backed securities, Toronto-based Sentry Select Capital Corp. introduced that market to Canadian investors in a big way with launch of Mortgage-Backed Securities Trust in the 2003. Sentry Select has since introduced three other closed-end trusts — including two in 2005 — that also invest in the U.S. MBS market. Claymore Investments entered this sector with its Adjustable Rate MBS Trust in early 2005.

The appeal of the U.S. market was an active repurchase (repo) market, which allowed the mortgage-backed securities to be used as collateral to be borrowed against. This allowed for leverage so that returns could be ratcheted up to appeal to Canadian income investors. The credit risk was nearly negligible, as U.S. mortgage-backed securities issued by government-owned or sponsored Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie Mae) are either explicitly backed by the U.S. government, or treated as if they are.

The returns of each trust would thus be less dependent on the actual return from the mortgage-backed securities. They would play a part, but the trust returns are more dependent on a spread — the difference between the returns of the portfolio’s MBS holdings and the cost of borrowing to invest. Because the portfolios were invested almost exclusively in AAA-rated securities, the borrowing costs were quite low. A spread of 90 basis points, levered 10 times, would be a 9% bonus to a simple mortgage-backed portfolio that might otherwise yield just 3% or 4%.

Because the returns were based in part on a spread in interest rates, these trusts were sold on their ability to deliver consistent returns over a complete interest rate cycle. New York-based Fixed Income Discount Advisory Company (FIDAC) managed the Sentry Select portfolios in a similar manner to its NYSE-listed Annaly Mortgage Management, which had a strong track record.

Market movements in 2005, however, pointed out the limitations of those assumptions. A combination of rising short-term rates and a flattening yield curve led to losses of between 12% and 20% on a net asset value basis for most of the Canadian mortgage-backed trusts. Investors still received regular distribution payments, which cut the losses on a total return basis to the neighbourhood of 8% to 12%.

Losses on a market price basis were more substantial. The two trusts that existed at the start of 2005 traded on the Toronto Stock Exchange at premiums to NAV of 12% and 20% in January 2005. By year’s end, the norm was a discount of 5% to 10%, in line with the discount of many other closed-end trusts.

More important than the paper losses for income investors are the cuts in distributions.

One trust, the original MBS Trust, cut its monthly distributions from 7.5 cents per unit to 6 cents in February, and then to 3.5 cents in December. In late January, the three oldest Sentry Select MBS trusts all reduced distributions, effective Feb. 28, 2006. MBS Trust distributions dropped from 3.5 cents to 2 cents, while MBS Adjustable Rate Income Fund and Sentry Select MBS Adjustable Rate Income Fund II both halved their distributions, from 6 cents to 3 cents per unit.

Over the course of 2005, the U.S. Federal Reserve jacked its key Federal Funds rate from 2.25% to 4.25%. Short-term bond yields moved in line, if not in step. Yields on 10-year treasuries balked however, moving lower through the first half of the year before finally moving up to end the year at 4.39% — just 17 basis points higher than at the start of the year, and actually lower than yields on two-year bonds.

This created a double-whammy for mortgage-backed security funds. The higher short-term rates increased the costs of borrowing. The portfolio’s longer-term mortgage-backed assets, which generally perform similarly to short-term bonds, declined. The result was a severe compression of the spread.

From a historical norm of a 1.20% to 1.40% spread, the spreads were as low as 0.15% in the third quarter, noted MFA Spartan II LLC, portfolio manager of Claymore’s Adjustable Rate MBS Trust in a December portfolio commentary.

In the press release announcing the reduced distributions, FIDAC chairman Mike Farrell specifically fingered the flattened yield curve and compressed spreads that have resulted from the U.S. Federal Reserve’s persistent rate hikes over the past 19 months.

“During the tightening phase of an interest-rate cycle, our cost of financing will rise faster than the yield on our assets,” Farrell said in the release. “Our results will reflect these conditions while they persist through spread compression, which reduces the amount of income available for distribution, and through pressure on asset values.”

Interest rate risk is one of two major risks faced by mortgage-backed security investors. The other major risk is not credit risk, as with other debt issuers, since the mortgage-backed securities in these trusts carry an actual or implied AAA rating. The other major risk is actually prepayment risk. Owners of a mortgage-backed security receive payments of interest and principal as the underlying mortgage loans are paid off. They trade on the market based on assumptions about interest and prepayment rates.

When mortgage rates are believed to be at lows and heading higher, prepayment activity increases. Mortgage owners are eager to pay off older mortgages at higher rates and lock in new mortgages at the lower rates. A surge in prepayments reduces the value of mortgage-backed securities — money repaid is no longer earning interest. Through much of the middle part of 2005, with 10-year bond yields under 4%, and mortgage rates perceived to be heading higher, prepayment activity rapidly increased as home-owners sought to lock in debt at these lower rates. Prepayments continue to be strong even as rates begin to move higher, because there is often a time lag as refinancings are completed. By the end of 2005, however, the prepayment activity waned.

The overall effect was a kind of a perfect storm for mortgage-backed securities. The combination of higher short rates, a flattening yield curve and a surge in prepayments is a virtual worst-case scenario for these assets.

There will no doubt be a reaction by investors to these securities, based on the market price swinging around the net asset value, plus the distribution cuts.

For investors who elect to stay in the sector, it’s not hard to imagine a recovery. Spreads between the security yields and borrowing costs could return to normal levels. In the third quarter of 2000, spreads were compressed to a low of 0.30%, but after the U.S. Federal Reserve stopped raising rates, spreads rebounded and returns on equivalent U.S. products were very strong over 2001 and 2002.

A steeper yield curve will generate more positive results. The prepayment amounts are being reinvested in the new higher rate environment, generating higher levels of income for the securities. The losses in a rising interest rate environment are recorded immediately since investments are “marked to market.” Over time, these losses can be offset by the higher levels of income earned at the higher rates.

Farrell noted that his company’s model often results in troughs in returns near the end of a Fed tightening, and that the prolonged and sizeable tightening has created better value in the market.

Still, income investors will want to see some evidence of a recovery after the distribution cuts. Sentry Select MBS Adjustable Rate Income Fund II (MGS.UN), the largest of the Sentry Select trusts will pay $0.03 per month. With a market price of about $7.70, that’s a yield of about 4.675%. The distributions from this trust, and most of the others in this space, are designed to be taxed at the capital gains rates, thanks to a structure in which the trusts actually own a portfolio of Canadian equities used as collateral by a counterparty to gain exposure to a portfolio of MBS investments. That 4.675% yield has the same after-tax yield as an income investment earning 6.8%.

Michael Barrett is a Toronto-based financial services writer and editor.

(03/03/06)