Investors are shying away from mortgage-backed securities despite a strong housing market and declining prepayment rates.
The fear of inflation and concern that the market could become flooded with securities is hurting the entire fixed-income sector, said Craig G. Ellinger, associate director for mortgage-backed securities at PPM America Inc. in Chicago.
The market is "getting crushed," he said. Mortgage spreads are "at or near the spreads of fall 1998, and still there's not that much buying," he said, referring to the liquidity crisis that hit the capital markets last fall.
Ken Boertzell, a portfolio manager for New York Life Asset Management in Parsippany, N.J., said he has stayed away from mortgages. "We've been underweighted, and we're happy to be that way. We're just sitting on the sidelines."
Investors are waiting to see whether bargain prices develop in upcoming weeks when a glut of new corporate bonds, asset-backed securities, and commercial mortgage-backed securities is expected.
Meanwhile, mortgages underperformed Treasuries last month, said Mr. Boertzell. Though surveys point to investors' remaining overweighted in mortgages, on Wall Street there is a "lack of liquidity, lack of sponsorship," Mr. Boertzell said.
"Mortgages are going to suffer the same malaise as other spread products," he predicted.
Rising interest rates have caused a slowdown in prepayments that should bolster the appeal of mortgages, said David Lereah, chief economist for the Mortgage Bankers Association. "Spreads are somewhat more normal, and refinancings have really stabilized between 20% to 25% of mortgage applications," he said. What's more, "there is little risk that rates will plummet because the economy is showing signs of strength," he said. "People believe the Fed is poised to raise rates rather than lower rates."
Indeed, some investors are cautiously optimistic. "Mortgages are positioned to perform well, and they do look attractive," said Deborah L. Boyer, vice president and portfolio manager at T. Rowe Price Associates Inc. in Baltimore. "The market as a whole, though, has basically repriced the value of liquidity," she said.
"Current coupon, conventional mortgage pass-through securities are probably the second-most-liquid product out there, aside from on-the-run Treasuries," she added. But she said the spread between bid and asking price has widened, indicating investor reluctance.
Ms. Boyer said she, too, is waiting on the sidelines for a more attractive opportunity that may be just around the bend. Many investors are expecting a large supply of corporate, commercial mortgage-backed securities and asset-backed securities this month. "A large supply is expected to hit the market, and we think that will cheapen up all spread products that are out there," she said.