Yields on Fannie Mae and Freddie Mac mortgage securities declined for a fifth day Wednesday, tracking a drop in rates on benchmark Treasuries and suggesting further declines in borrowing costs for new home loans.
The yield on Fannie's current-coupon 30-year fixed-rate mortgage bonds fell 6 basis points from Tuesday's close, to 4.52% as of 10:55 a.m. Eastern Daylight Time, the lowest since May 29.
Treasuries and agency mortgage bonds rallied after a government report showed the cost of living rose less than forecast last month.
The mortgage bond yields reached 5.07% on June 10, the highest level since the Federal Reserve Board announced plans to buy home loan bonds in November.
The difference between yields on the Fannie bonds and 10-year Treasuries fell 2 basis points Wednesday, to 90 basis points. The gap, which grew to as much as 238 basis points last year, contracted to 70 on May 22, the lowest since 1992.
Rising yields helped the average rate on a typical 30-year loan in the week that ended June 11 climb 77 basis points from three weeks earlier, to 5.59%, according to Freddie. The loan rate hit a low of 4.78% on April 30.
According to Bankrate.com, as of early Tuesday the rate had dropped to 5.53% after hitting a six-month high of 5.74% on June 10.
Yield spreads over 10-year government notes on the mortgage bonds hit a two-month peak of 114 basis points on June 8.
Hedging by investors and servicers had driven some of the recent increase in Treasury yields and spreads on home loan bonds, but that dynamic is now being reversed.
As rates increase, the expected average lives of mortgage bonds and servicing contracts extend as the potential for refinancing drops, leaving investors with portfolios of longer-than-anticipated durations. Investors then may seek to pare durations by selling longer-dated Treasury securities, mortgage bonds and rate swaps, sending yields even higher.
The opposite happens when rates decline.
As of Tuesday the duration of the agency mortgage bond market had extended to the equivalent of about $1.9 trillion of 10-year Treasuries, or almost double the yearend level, Chris Ahrens, Jeana Curro and Eric Liverance, three UBS AG strategists in New York, wrote in report published Wednesday. (The duration is an estimate of how much the price of a bond would change if interest rates rose or fell.)
The duration of fixed-rate agency mortgage bonds had fallen to 3.18 years as of Wednesday, versus a seven-month high of 3.85 years on June 10, according to Barclays Capital index data.
"For those who believe rates will go down, hedge ratios will certainly shrink, which will result in an immediate contraction as borrowers refinance," the UBS analysts wrote. "We do not expect to see 4.875% mortgage rates anytime soon." As a result, "the market will stay extended for some time."