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The yield on the 10-year bond has fallen below 1.7% after rising above 2% in mid-March
The 10-year bond directly influences virtually all long-term liabilities in the U.S. From mortgage rates to corporate borrowing rates, the 10-year is the baseline. Because of this, the Fed has been buying Treasuries directly in an effort to lower borrowing rates across the board. Currently, the Fed is purchasing virtually all net new issuance of U.S. government securities. As long as the job market continues to under-perform, the Fed will be pulling out all the stops to keep interest rates low.
2013 was supposed to be the year of the bond bear market
Late last year, the theory on 2013 was that it would be the year of the Great Rotation, where investors would move out on the risk curve, buy equities, and sell Treasuries. So far, that hasn’t happened as fund inflows for both equities and bonds are increasing at about the same rate. In the Federal Open Market Committee meeting minutes, there seemed to be a consensus forming that quantitative easing would end sometime this year. Subsequently, certain Fed officials have contradicted that view, or at least have qualified it. So the equity part of the rotation is occurring, as the S&P 500 hits new highs, but the bond part is not working out as anticipated.
The new quantitative easing initiative from the Bank of Japan is adding even more demand for the 10-year as Japanese investors exit Japanese Government Bonds for Treasuries. While a 1.7% yield may seem unappetizing to many U.S. investors, rates are even lower in Japan, where the 40-year bond yields a mere 1.34%. Japanese investors are also benefiting from a drop in the yen, which does add some return as well. This accounts for the dramatic drop in yields over the past several days.
Impact on mortgage REITs
The absolute level of interest rates is a prime driver of mortgage REITs like AGNC, NLY or CMO. Mortgage-backed securities closely track the level of long term Treasuries, although there are not quite as sensitive. As interest rates fall, their interest margins fall, which is the difference between the rate of return on their assets and their borrowing costs; this drop will reduce their profitability.
Falling interest rates also affect another important factor for mortgage investors, which is prepayment speed. Homeowners are allowed to pay off their mortgage early, without penalty. So when interest rates fall, those that can refinance at a lower rate will do so. This is something that is good for homeowners, however, it isn’t necessarily a good thing for mortgage lenders, especially REITs. When homeowners prepay, the investor loses a high-yielding asset and is forced to re-invest the proceeds in a lower rate investment. This means lower returns going forward.
© 2013 Market Realist, Inc.