NEW YORK (MarketWatch) -- Some bond investors are expecting mortgage rates to rise as the Federal Reserve finishes its planned purchases of nearly $1.5 trillion in mortgage-related bonds, yet another risk to the fragile U.S. recovery.
The central bank may address its plans to unwind this program, one of its biggest of forays into the private credit markets over the past year, in Wednesday's policy statement. "Once we don't have the largest incremental buyer of mortgages, who will step up to take that role?" asked Todd White, a bond portfolio manager at RiverSource Investments.
"It probably won't be a smooth transition, assuming rates are near where we are currently."
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Since the central bank said nearly a year ago it planned to buy up privately held mortgage-related bonds, eventually becoming the largest buyer of mortgage-backed securities, mortgage rates have tumbled to just over 5% from more than 6%
Fed officials and many economists credit the Fed's plans to buy $1.25 trillion in mortgage-backed securities and $200 billion in debt sold by Fannie Mae (NYSE:FNM) , Freddie Mac (NYSE:FRE) and Ginnie Mae, for weighing on rates. It's already finished the bulk of the purchases, expected to end in March.
Other factors also helped improve dynamics in the mortgage, including a lower supply of new mortgages.
Still, given the size of the Fed's role in this obscure but huge market, which makes up about a third of all U.S. bonds outstanding and takes up a sizable chunk of most bond mutual funds, they are worried that the Fed won't be able to engineer a graceful exit. Any sharp rise in rates could cut off the tenuous recovery in the nation's hard-hit housing market.
"Everyone is sitting there looking at the door," said William Chepolis, who helps manage the DWS Strategic Income Fund (FUND:KSTAX) .
"We have a lower position in the mortgage market than we have [had] in two years because I just don't think these prices are sustainable. There will be an upward adjustment there and mortgage will follow."
Even Pimco's Bill Gross has busily sold off his mortgage-related securities after earlier recommending investors buy what the Fed is buying. See Fund Watch.
In its favor, the Fed has already ended one debt-buying program without disrupting the market. Last week, it wrapped up its $300 billion in Treasury purchases. Yields on the benchmark 10-year note barely budged and have hovered near 3.5%, or 45 basis points lower where they were in June.
After last month's meeting, the Federal Open Market Committee said the committee will slow the pace of its mortgage-bond purchases "to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010."
Mind the gap
Mortgage rates, like many other loan products, are usually priced at a certain amount above Treasury securities.
Since the Fed has become the 800-pound gorilla in the mortgage market, the gap between Treasurys and other rates has narrowed sharply, reflecting reduced investor fears about holding mortgage debt compared to safe-haven Treasurys.
The spread between yields on mortgage bonds and Treasurys has fallen to 0.15 percentage points, according to Bank of America's Merrill Lynch unit. That's the lowest since 1998 and way below the long-term average. In December the spread was 1.92 points.
This year, as those spreads narrowed, the Fed has bought $977 billion in mortgage-backed securities, according to Morgan Stanley. It has also bought $147 billion in agency debt.
As a result of those lower yields, mortgages are having their best year since 2002, according to Merrill Lynch. Mortgages have returned 5.91% so far in 2009.
A large part of that rally is due to the Fed. Its purchases are a sizable portion for the $8.95 trillion mortgage market, which is the largest segment of the overall U.S. bond market, according to the Securities Industry and Financial Markets Association.
You probably own them
The moves in the mortgage market don't just affect homeowners. They also affect every bond investor, as most fixed-income mutual funds own them.
Of the thousand or so taxable bond portfolios tracked by Morningstar, about four out of 10 have more than 20% of their assets in some kind of mortgage-related debt.
Also helping the mortgage market, there has been less securitization of mortgages into various products compared to recent years. Part of that stems from the disappearance of the riskier, subprime-type mortgage loans, but more broadly, banks are much more reluctant to lend. A thinner supply of new mortgages has also helped compress yields.
Someone else will buy
Some investors, however, say other buyers will replace the Fed in the mortgage markets, keeping rates low.
"The mortgage rate may drift higher but not markedly so," said Robert Tipp, chief investment strategist at Prudential Fixed Income Management, which oversees more than $200 billion of bonds.
Part of his confidence stems from a bigger trend that many analysts have noticed in recent months: investors moving money out of money-market funds and into other assets, including tip-toeing out the risk spectrum to Treasury securities.
The lukewarm outlook for the economy would argue for Treasury rates to remain relatively stable, providing an underlying support for mortgage rates.
"The Fed is hoping it will be able to slink away from the mortgage-buying program without creating any major waves in the market," Tipp said. "I think they will generally succeed."
Also, the Fed will continue to be vested in keeping borrowing accessible. If mortgage rates size substantially -- what Tipp describes as three-quarters of a percent to 1.25% from current levels -- "the Fed would be looking at ways of bringing rates down," he said. "They wouldn't stand idly by."
