After a record rally, mortgage bonds are poised to slump in March when the Federal Reserve curtails a program to purchase $1.25 trillion of the securities, likely driving up interest rates on loans for new homes.

Analysts said the extra yield over benchmark rates that investors demand to hold the securities will widen as much as half a percentage point as the Fed stops purchasing. The 11-month-old program has reduced yields, which guide lending rates, by about 1 percentage point, according to estimates from BNP Paribas SA.

The Fed has been buying at "way" narrower spreads than "where the private sector would be willing to" invest, said Doug Dachille, the chief executive of First Principles Capital Management LLC, which oversees about $8 billion of fixed-income investments.

Rising yields mean loan rates are likely to end 2010 almost 0.75 percentage point higher than they are currently, based on forecasts for government bonds and spreads, adding to challenges for a housing market struggling to recover from its worst slump since the 1930s. Fed Chairman Ben Bernanke's goal in 2009 was to lower the costs for consumers to borrow and help bolster the economy as banks curbed lending.

So-called agency mortgage bonds guaranteed by companies such as Fannie Mae and Freddie Mac returned 4.8 percentage points more than Treasuries last year, their best performance in at least 20 years, according to data compiled by Barclays Capital.

In 2008 the debt returned 2.15 percentage points less than government notes.

The Fed began purchases in the $5.4 trillion market of securities guaranteed by the government-sponsored enterprises Fannie Mae and Freddie Mac, or the Government National Mortgage Association, a federal agency, in January 2009. So far it has acquired a net $1.1 trillion.

Yields on Fannie Mae's current-coupon 30-year, fixed-rate mortgage bonds were 4.53% last week, below the average of 5.59% for the five years through 2008, according to data compiled by Bloomberg News.

The bonds yield 0.74 percentage point more than 10-year Treasuries, compared with the average of 1.27 percentage points over the past five years, and were as high as 2.38 percentage points in March 2008. The spread was 0.68 percentage point on Nov. 24, the narrowest since 1992.

Banks will probably buy more of the securities as that gap widens, limiting increases, according to John Anzalone, head of research and trading for mortgage bonds at the institutional unit of the Atlanta asset manager Invesco Ltd.

"Banks are buying Treasuries right now, so you've got to figure at some point" mortgage bonds will be in demand, said Anzalone, whose firm oversees $414 billion of assets. "The question is just how far" spreads need to widen, he said.

Commercial banks' holdings of Treasury and agency debt excluding mortgage securities have risen $93.9 billion since June 30, to $424.7 billion, while their investments in agency mortgage bonds have expanded $16.3 billion, to $1 trillion, Fed data shows.

The rally in the bond market helped pushed the average rate on a typical 30-year fixed mortgage to a record low of 4.71% in the week that ended Dec. 11, according to Freddie Mac. Though the rate rose to 5.05% last week, it was below the average of 6.05% last year and the high of 8.64% in May 2000.

The Fed may decide to continue purchasing mortgage bonds if the rebound in the property market proves short-lived, Invesco's Anzalone said. Bernanke said in Dec. 3 testimony to Congress that officials "will have to see how the economy is evolving and whether or not we need to do more."

Though the S&P/Case-Shiller index shows home values are rising after a record 33% drop from 2006, Scott Simon, Pacific Investment Management Co.'s mortgage bond head, said such data is misleading because of a temporary curb on home seizures tied to government antiforeclosure efforts that will reverse next year.

The central bank stopped buying Treasuries in the last week of October. Since then the yield on the benchmark 10-year note has risen to 3.79%, from 3.50%. It's expected to rise to 3.97% by the end of this year, according to the median estimate of 60 economists and strategists surveyed by Bloomberg.

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