On the heels of the Lehman Brothers bankruptcy in late 2008, the U.S. Treasury and Federal Reserve Board (the “Fed”) rolled out a number of unprecedented programs designed to inject liquidity into the financial system. The mortgage purchase program began in conjunction with the Troubled Asset Relief Program, or “TARP,” and both were designed to help financial institutions that held mortgage-related assets – which at that time essentially had become unsellable – gain access to much needed capital. On March 31, 2010, the Fed officially ended one leg of that campaign by concluding its purchase of mortgage-backed securities (MBS).
Why did the program end?
The Fed had originally targeted purchasing up to $600 billion worth of MBS, but expanded its purchase program in March 2009 as the markets and the economy continued to flounder. For some time now, the Fed had set a target of completing its MBS purchase program by the end of March 2010, and although we can’t say for sure, presumably the Fed feels the economy today is stable enough to warrant taking the first steps in unwinding its quantitative easing policy.
What are the implications for the bond market now that this program has ended? Although the end of the purchase program had been clearly communicated well in advance, the implications for the bond market are potentially still significant. Since the program began, the Fed and Treasury have increased their stake in the agency MBS market from approximately 1.5% to more than 27%. At the same time, private investors, such as mutual funds, hedge funds, and other investment vehicles, have significantly reduced their positions. The result throughout the mortgage market has been tighter spreads, meaning the yield difference between U.S. Treasuries and MBS became relatively small. With the program now ended, I don’t believe that yields on MBS will rise significantly over the near term. The Fed, after all, has no plans to begin selling the securities on its books. But the risk to that view is that if net demand for MBS declines, the market could become more volatile in the short run.
Given the possibility for heightened volatility, how are the funds positioned?
We remain cautious on the MBS sector and have been very discerning in our security selection, mostly targeting non-agency mortgages that possess different characteristics than those that the Fed had been buying. Putnam Income Fund currently has neutral to below-benchmark exposure to MBS, and may maintain that stance until the supply/demand characteristics of the market become more balanced. The exposure the fund does have to agency securities has been primarily through collateralized mortgage obligations, or CMOs. This has also been true of our funds that concentrate on the mortgage markets, such as Putnam American Government Income Fund. In both cases, we’ve favored CMO positions in interest-only securities. These securities are backed by the interest payments on mortgages and, in general, the longer homeowners take to repay their mortgages, the more valuable they become. Given the prospect for rising mortgage rates, which usually lead to a slowdown in refinancing and prepayment activity, the market has been favoring these types of securities, and our positions in them have performed well.
Consider these risks before investing: Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. The use of derivatives involves special risks and may result in losses. Funds that invest in bonds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Unlike bonds, bond funds have ongoing fees and expenses.
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