Mortgage-backed securities, especially those paying higher rates of interest, are back in favor.
Last week, investors seemed to have found their appetites for these bonds as the fear of a sharp spike in refinancings by homeowners and a surge in home sales abated.
Instead, buyers were focused on the need to invest cash and take advantage of the higher yields on these securities over comparable Treasury yields.
Some market observers are calling this a capitulation, especially by domestic portfolio managers who shunned mortgage securities all year and groused that prices were too high.
Now it is almost September, prices remain high and fund managers who put their money in other short-term investments, which are beginning to mature, are going back to mortgage bonds.
They say that, despite the prices, these bonds offer irresistible yields — about 150 basis points over comparable Treasurys.
Dealers also recommend them to their customers.
"Not everybody is in love with this market," said Michael Graf, the head of U.S. short rates trading at Barclays Capital, "but they are not in love with the alternative, which is sitting on cash."
On Friday, in a move that could draw even more buyers into the market, prices on mortgage bonds fell sharply.
The downward pressure was primarily due to underperformance of Treasury bonds and the selling of new mortgage bonds into the market.
The lower coupons felt the bulk of the pressure as securities backed by mortgages issued in the last few months are likely to carry a coupon of 4% to 5%.
The Fannie Mae 30-year bond with a 4% coupon fell 15/32, or $3,124 for every $1 million investment.
However, the higher-coupon bonds fared better.
Prices on Fannie's 6.5% bond fell slightly, by 2/32, to 108-24, according to Tradeweb data.
Much of this is because investors have realized that these securities, with interest rates of 5.5% and higher, overcorrected in the past month.
Speculation and fear that the government would initiate a refinancing program for borrowers who would not otherwise qualify for a new loan in the current stringent lending climate — such as people who owe more than their homes are now worth — caused prices on these bonds to crater.
Investors feared that these bonds, which were trading for more than 109 cents per dollar of face value because of their high interest payouts, would be redeemed at face value.
However, those rumors have now been mostly put to rest.
These "coupons are benefiting as actual prepayments are likely to fall short of market expectations," according to the Barclays analysts.
Despite this prediction, prepayments could prove to be a risk on bonds newly issued in 2009 and 2010, which carry 4%, 4.5% and 5% rates of interest.
These bonds are backed by loans made in the past 18 months to borrowers with good credit.
As 30-year, fixed-rate mortgages average 4.36%, according to the latest Freddie Mac survey, and as expectations grow that they will drop in coming months, it starts making economic sense for some of these borrowers to refinance despite the fees they must pay.
The volume of homeowners looking to refinance picked up in the last couple of weeks, but it will be a short wave with not too much of an impact, said Mahesh Swaminathan, a strategist at Credit Suisse.
