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Risky-mortgage investors show doubt

NEW YORK -- Investors who piled into bets on some risky types of U.S. mortgage bonds are showing signs of doubt that the notes will extend their rally.

Bondholders last week sought to sell the most government-backed mortgage derivatives known as interest-only (IO) securities and inverse IOs through auctions in four months, according to Empirasign Strategies LLC, which tracks securitization trading.

Because the bonds have no principal, their returns are especially sensitive to the pace of homeowner refinancings and property sales, which tend to pick up as interest rates fall.

Even as benchmark rates have retreated, interest-only spreads have “tightened relentlessly over the past year,” pushing “many” measures of their relative yields to record lows, according to JPMorgan Chase & Co. (NYSE: JPM) analysts led by Matt Jozoff and Brian Ye.

Demand has been bolstered by the “underwhelming” pace of prepayments, falling rate volatility and a desire for protection against rising yields, they wrote in a July 25 report. The gains may make the market more vulnerable if bond prices rise further.

“Investors thus far have shown resistance against capitulating on rallies as refinancing remains subdued, and replacing the bonds at higher rates has generally come with tighter spreads,” Bank of America Corp. (NYSE: BAC) analysts led by Satish Mansukhani and Chris Flanagan wrote in a July 25 report.

“This creates a certain asymmetrical risk to IOs at a sub-4 percent mortgage rate, when refis could really pick up.”

Dealers circulated bondholder auction lists for $1.5 billion of the securities last week, compared with a weekly average of about $900 million since the end of March, according to New York-based Empirasign Strategies.

The average rate on a typical 30-year fixed mortgage fell last week to 4.13 percent, from 2013’s high of 4.58 percent in August, according to surveys by guarantor Freddie Mac.

The drop has done little to spur refinancing, with applications hovering at about a six-year low, according to the Mortgage Bankers Association.

At the same time, IO spreads have tightened about 3 to 4 percentage points over the past year, reaching about 1 percentage point under one calculation for a certain type, according to the report by JPMorgan.

“There is likely limited room for further spread compression,” the bank’s analysts wrote.

The attractiveness of the debt has also been boosted by the cheap financing available in the so-called dollar roll market for mortgage securities used as hedges, which has been caused by the Federal Reserve’s bond buying, the analysts said.

IOs are made as investment banks and other firms create collateralized mortgage obligations, also known as mortgage derivatives, out of simpler pass-through securities, separating the payments into new notes with differing characteristics.

Inverse IOs carry coupons that move in the opposite direction of short-term rates. The size of notes reflect notional amounts, or the quantity of underlying debt used to calculate payments, which declines as mortgages get repaid.

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