Buy What Ben Bernanke is Buying and Make a Profit (BOND, MBB)

Unless you’re as clueless as a NFL replacement ref, you’ve heard by now about QE3… The FOMC’s plan is to buy $40 billion in mortgage-backed securities a month for as long as it deems necessary. The hope is to spur more home-buying and thus create more jobs.

The FOMC stated in their meeting’s minutes that if they didn’t do anything, “economic growth might not be strong enough to generate sustained improvement in labor market conditions… strains in global financial markets continue to pose significant downside risks to the economic outlook.”

There’s been a consensus among economists that QE3 won’t end up trickling down to help everyday Americans buy a home. Rather, it’s likely to be great for banks – go figure.

Mortgage-backed securities soared in their best day in nearly four years because of the announcement. The Fed’s plan to buy the additional $40 billion a month in bonds went beyond what the market expected.

I went over this a few weeks ago, but here’s the refresher:

The purchasing of mortgage-backed bonds allows the central bank to lower the rate at which banks can sell their loans through government-sponsored entities like Fannie and Ginnie Mae and Freddie Mac and their securitization programs. They fund about 90% of America’s home loans.

Once again you may think it’s the big banks winning out over the citizens. But this time there may be an opportunity for you to get in on the fun with mortgage-backed bond ETFs.

A Mortgage-Backed Bond Recap

Mortgaged-backed are asset-backed securities secured by a number of mortgages. What a government or financial entity will do is purchase and bundle mortgages into pools and then sell the expected mortgage payments to investors in the form of bond-like securities.

This process was and still is a vital component of today’s mortgage market, or most other credit markets for that matter, since securitization frees up capital that can then be used to make more mortgages.

Some investors are seeing them as a better bet than Treasuries. First, there are the Fed’s actions. Secondly, they pay better. Here’s why.

According to Morningstar, “Government-sponsored mortgage bonds typically pay more interest than do comparable U.S. Treasury bonds. However, because homeowners can refinance or sell their homes at any time, mortgage-bond cash flows are very unpredictable. This ‘prepayment risk’ is why the bonds pay higher interest rates.”

And now you’re asking, what is this “prepayment risk?” It’s a familiar concept to any homeowner.

It’s when someone prepays or pays off their mortgage because rates are now lower than what they’re currently paying – like refinancing your home. If you’re paying an interest rate of 6% and current rates are 4%, you’re more likely to refinance to get the lower rate.

However, when you refinance, some investor out there just lost a stream of payments he was investing in. Also, rising home prices will give homeowners a “George Jefferson moving up to the East side” incentive to buy a bigger and better place. This will also lead to mortgage prepayments.

This real possibility for cash stream loss must be compensated for.

The Market Had an Immediate Response to the Announcement

Let’s look at what the industry analyst saw.

According to Credit Suisse, Fannie Mae’s mortgage-backed security with a 3% rate rose 1 10/32 points. This blew away the 10-year Treasury by 1 4/32 points. How meaningful is this? The relationship between the two instruments usually ranges any given day by less than 5/32 point.

Nomura Securities stated, “The central bank likely will be buying half of the $140 billion of the mortgage-backed debt that Fannie Mae, Freddie Mac and Ginnie Mae sell each month.”

Barclays indexes reported, “Fed participation in the market has helped lift investor returns to 2.42% this year through Wednesday, a full point more than Treasuries.”

Sterne Agee chief market strategist Sharon Stark in a note stated, “Beneficiaries of the Fed’s accommodative policy in the fixed income sector include both agency and non-agency MBS and asset-backed securities… The Fed’s plans to add to its existing holdings of $843 billion Fannie Mae, Freddie Mac and Ginnie Mac MBS… comes at a time when supply is sparse and demand from financial institutions insatiable.”

How to Get a Piece of This Action…

The iShares Barclays MBS Bond Fund (NYSEArca:MBB) put up its best day in over a year after the FOMC announcement. This is an ETF that tracks an index of U.S. investment grade agency mortgage-backed securities. It also gives a 30-day SEC yield of 3.2%.

Another option is the PIMCO Total Return ETF (NYSEArca:BOND). This ETF had 45% of its holdings in mortgage securities at the end of last month. Bill Gross has been under fire this year but it seems he was betting – and betting correctly – on the fact that the Fed would go through with QE3.

In an article with Dow Jones Newswires, he likes were he is positioned. The fund “is well positioned for this announcement,” Gross stated in the article.

Dow Jones Newswires also reported, “Gross has systematically concentrated his fund on MBS [mortgage-backed securities] for months as he placed bets that the elevated unemployment rate and still tepid pace of economic recovery would push the Fed to provide additional support for the economy.”

Morningstar did a comparison where PIMCO Total Return ETF is up 3.1% over the last three months versus 1.1% for the Barclays U.S. Aggregate Bond Index.

QE3 will be around for some time. So expect the mortgage-backed bond industry to benefit from the Fed’s buying – and so should you.

Good Investing,

by Jason Jenkins, Investment U Research

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