Bonds Regain Favor After Fannie & Freddie Takeover

While the impact of the Fannie Mae-Freddie Mac bailout on stocks is less than certain, the rescue plan has created a new enthusiasm for bonds.


In particular, mortgage-backed securities have regained favor with investors after the government seized the two mortgage giants, effectively taking over their $5 trillion in debt and pledging $200 billion in capital to cover expected losses.

At the same time, investors are also preparing to step up buying of corporate bonds as well as Treasurys after the government intervention assuaged uncertainty about the security of the debt instruments.

"I was a big buyer of (mortgage-backed) bonds until a couple months ago. I took a six- to nine-week vacation from buying just in case," says Dennis J. Barba, managing partner of the Oxford Group of Raymond James Associates in Cleveland. "With what just happened we'll start purchasing those bonds again for our clients. I think it's a little safer to go in the water than it was a few weeks ago."

Barba is not alone in his enthusiasm for mortgage debt.

The $4.5 trillion industry had what some analysts believed to be its biggest day Monday, the first trading day after the bailout announcement.

Banks made about $20 billion selling the holdings as risk premiums over Treasurys fell by 40 basis points. The trade surged in part after two of the nation's leading bond traders, Pimco's Bill Gross and The Vanguard Group's Kenneth Volpert, said on CNBC that they would be buyers.

"Stick with the partner that brought you to the dance," Gross said. "Basically mortgage securities are attractive here because the Treasury announced that they were going to be buying them in the future. You want to buy them now and sell them back to the Treasury in the future at a higher price."

Watch video at left for analysis from Gross and Volpert.

But Barba advises caution in the trade and said he is buying mostly short maturities and not going into the long end of the market, on the belief that there's more trouble ahead for mortgages that will send risk premiums higher.

"What the Treasury announced doesn't end this mess," he says. "It just takes a little bit of the gray out of the equation."

Mortgage-backed debt can be purchased through brokerages and comes mostly from Fannie and Freddie.

Corporate Bonds Also Attractive

A newfound appetite for debt also is helping corporate bonds prosper.


The average corporate bond yield of nearly 6 percent is an attractive enticement for investors amid a wobbly stock market, and some money managers have been parking their assets there until the equity storm and the credit crunch blow over. The bailout news helped sweeten the pot.

"At this point we're still staying away from financial service corporate bonds, but we do like those of industrial companies and other industries that aren't really tied into the financial crisis at the moment," says Emily Sanders, president and CEO at Sanders Financial Management in Atlanta.

Barba also likes corporate debt, and said he has bought short-term notes for his clients in companies including Goldman Sachs, Merrill Lynch, Citigroup, owner General Electric and Hartford Financial ServicesGroup.

One obstacle to investing in such debt, though, is you generally need pretty deep pockets. Most corporate debt is bought in increments of $5,000 or $10,000, and the cost can get much higher for mortgage securities.

The difficulty in making investments in smaller denominations comes in part because of the markup, or the price that a dealer charges compared to the actual price of the bond. High markups for corporate debt make the investment profitable only in considerable volume.

To make the trade, Sanders says smaller investors can buy exchange-traded funds that don't have all the cost, risks and restrictions of the various debt types but track their movements.

One such ETF is the iShares Lehman Credit Bond fund that reflects the U.S. investment-grade credit sector of the bond market as defined by the Lehman Brothers U.S. Credit index. Sanders Financial has purchased the ETF for its clients.

"Particularly for retail investors that are either on fixed incomes or fully retired or nearing retirement, corporate bonds can be a good way to bring in some steady interest income without taking on as much volatility in the equity markets," Sanders says. "There's a lot of solid companies that issue corporate debt."

Benefits For Banks

Financial institutions that had been taking a beating over their mortgage losses have been the primary beneficiaries of the Fannie-Freddie bailout, although their shares were mostly lower in Tuesday trading after huge gains the day before.

Lenders have posted more than $500 billion in credit losses and writedowns during the credit crunch as foreclosures have hit record levels in some areas and property values have tumbled.

"Banks had been a little over $40 billion under water relative to their book costs for securities overall, and with (Monday's) move and the tightening in mortgages, we estimate that helps bring that to only about $20 billion under water," says Matthew Jozoff, head of mortgage strategy at JP Morgan.

Real estate investment trusts also have benefited as the veil of uncertainty was removed from the market. The handful of REITs that invest in Fannie and Freddie debt had "outperform" ratings reaffirmed by a KBW analyst after the bailout took hold.

"There has been a lot of demand on the sidelines, and this brings clarity to bring those buyers off the sidelines," says Michael Hough, chairman and CEO of Hatteras Financial .

Hatteras shattered quarterly earnings expectations and on Monday posted its highest single-day gain in nearly three months.

-- Reuters contributed to this report.