Despite stirring in the U.S. housing market, many fixed-income players are casting their bets with mortgage securities.
Recent high prepayment rates, which can force mortgage bond-holders to reinvest at lower rates, may be topping out -- or were distorted to begin with, analysts say.
And with corporate bond yields running at historically tight spreads to U.S. Treasuries, some money managers are opting for mortgages instead.
Just months ago, home owners sent chills through the $1 trillion mortgage securities market as they rushed to pay down their mortgages, lifting prepayments as much as 70% in April.
Now, "the general consensur is that [prepayment] speeds are going to slow down," said Andrew S. Carron, director of fixed-income research at First Boston Corp. "Our view is that prepayments as a result of refinancings will begin to slow, as a result of higher rates since February, though prepayments as a result of housing market activity will continue to be strong."
That means faster prepayments among discount coupon securities and slower prepayments on premiums issues -- just what recent data show.
Prepayment figures released Monday by the Federal Home Loan Mortgage Corp. indicate that while nation's housing industry may be recovering, it is certainly no fireball.
For the mid-May to mid-June reporting period, discount and current coupon issues showed modest prepayment increases, while prepayment among Freddie Mac's high-coupon securities actually declined. Prepayments climbed 7.4% for Freddie Mac's 8.5% and 9% coupon issues, while prepayments on its 10 1/2s fell 17%.
"The market has consistently underestimated the acceleration of prepayments on discounts," Mr. Carron said. "And on premiums, our feeling is that prepayments are no longer accelerating, though they will maintain their currently fast levels."
Richard Ellson, mortgage analyst at Donaldson, Lufkin & Jenrette Securities Corp., agreed, saying, "I think the refinancing surge is over, so you should see 11s, 10 1/2s, and 10s come down somewhat."
To be sure, the housing market is showing sure signs of life. New home sales for May, due out today, are expected have risen a 2.0%, to 510,000 units -- the fourth consecutive monthly rise.
But "there are some sectors of the country that have seen the equity of their homes diminish," said Peter Van Dyke, money manager at T. Rowe Price Associates in Baltimore. "Those people can't afford to move -- they're frozen in place."
Mr. Van Dyke said he is more bullish about mortgage securities than corporates, adding, "we've come through a period of accelerating prepayments and still spreads didn't widen. At this point, you've got to show me."
Triple-A 30-year securities of the Government National Mortgage Association now yield about 91 basis points more than Treasuries and just 10 basis points less than long-term A-rated industrial corporates.
"Corporate spreads -- especially in some of the financials and single-A industrials -- have come in too much," Mr. Van Dyke said. "Certainly we've seen some of the banks and weaker financials widen out over the last month or so as this euphoria faded."
Despite jitters over prepayments, mortgage securities turned in the best performance among fixed-income securities in May, posting a total return of 0.86%, according to Salomon Brothers Inc. What's more, mortgages were the only sector to record a principal gain, with 0.1%.
Corporates -- which have returned 6.42% year-to-date versus mortgages' 4.82% -- registered a 0.73% total return in May, while governments trailed with 0.36%.
"There's been a positive attitude toward the corporate market, but there are some inklings of concerns and the mortgage market may benefit from a general flight to quality," said Monica Barry, vice president at First Boston. "Corporate spreads suggest a stronger recovery than we might be seeing, and if you start to get widening in the mortgage market, it's going to have happened in corporates first.
"For people looking for yield, the natural place to look is agencies and CMOs," Ms. Barry said.
Still, recent high prepayment data have spooked some buyers.
"We're pretty much in current-coupon issues," said M. Elliot Randolph Jr., senior fixed-income manager at 1800 Capital Management, a unit of Alex Brown & Sons. "We're very defensive. In this period of high refinancing, I wouldn't venture in to buy Ginnie Mae 12s."
Complicating matters, some analysts have suggested the spring spike in prepayments may have been more illusion than reality.
Historically low short-term interest rates may have prompted some homeowners to "curtail" their mortgages, that is, pay them down beyond amortization as alternative to other short-term investments.
Analysts argue that curtailment can shorten the weighted average maturity of a mortgage pool, exagerating prepayment rates and causing the market to over price high discount coupon issues and under price low premiums.
"I believe there's a widespread occurrence" of curtailments, said Joseph Hu, senior vice president at Nomura Securities International. "If it's happening and the market believes it and prices the securities accordingly, it would tend to depress the prices of higher coupons, like 9s or 10s. And if this is proved, the speed" of reported prepayments will come down significantly and the mispricing will be corrected.
But others note that curtailment is a drop in the bucket compared with prepayments due to refinancings or housing activity.
Take a Fannie Mae 9 1/2s that had a weighted average maturity of 2016 when it was issued in 1986. As of of May 1991, the weighted average maturity would be 25 years and one month if there had been no curtailments.
But the actual figure was 24 years and five months, so curtailments trimmed eight months off the weighted average maturity. That means homeowners prepaid their scheduled amortization by about 0.6% of the outstanding loan balance over those five years -- a fraction of the 32% of the loan balance accounted for in regular prepayments.
Worse yet, the troika of agencies that dominate the market do not break out curtailments from their regular prepayment data.
"We're all aware of it, but there are no hard data," said Donaldson's Mr. Ellson. "But there is some speculation that on some of the higher-coupon mortgages, prepayments are higher than they would be from pure refinancing activity because of curtailments."
The Metropolis of Tokyo served up its sixth "Yankee" bond issue since returning to the U.S. capital markets in 1986.
A Goldman, Sachs & Co. team priced the $200 million offering of 10-year notes as 8.65s to yield 43 basis points over the Treasury curve. That spread was at the low end of market expectations.
The Japanese capital, which carries triple-A ratings from the major agencies, will use the proceeds for general municipal purposes, including the Haneda-Oki land reclamation project, a subway construction project, and sewerage construction and improvement projects.
The offering was the day's sole issue.
In the secondary market, both investment-grade and high-yield bonds wound down little changed, as traders did housekeeping ahead of the July Fourth holiday.