Monday, May 18, 2009

Pimco’s Simon Says Mortgage Bonds Are Still Good Buys

U.S. home-loan securities without government backing are worth buying even after a two-month rally has lifted prices to the highest since October for some types, Pacific Investment Management Co.’s mortgage-bond chief said.

“The sector had just gotten stupidly cheap,” said Scott Simon of Pimco, the largest bond manager. “And on any kind of loss-adjusted basis, stuff is still really cheap. If you didn’t know about the last few months, you’d never know how it’s gotten here. You can run some pretty draconian scenarios and get awfully high yields still.”

Typical prices for the most-senior prime-jumbo securities jumped to about 83 cents on the dollar on May 14, from about 63 cents March 19, according to Barclays Capital. Similar bonds backed by Alt-A loans with a few years of fixed rates climbed to 45 cents, from 35 cents, according to the bank’s reports.

“Non-agency” mortgage bonds have generally risen after declines to record lows or near-nadirs amid soaring homeowner delinquencies, tumbling home prices and capital-depleting losses at financial companies. The rally began after the March 23 announcement of the U.S. government’s plan to co-invest with and lend to buyers of the securities to bolster lending, under the Treasury’s Public-Private Investment Program and Federal Reserve’s Term Asset-Backed Securities Lending Facility.

‘Big Emotional Thing’

Pimco’s Simon said in a May 15 telephone interview that it isn’t clear the initiative has been the biggest cause of the gains. Among other things, he cited previous drops to levels he called overdone as potential buyers held out for high returns, a rise in prices across asset classes, changes to bank accounting rules and a slowing of the global “deleveraging.”

The securities may soon drop again for some period of time, with the status of the PPIP plan being a potential spark for a pullback, he added. Since the start of last year, senior prime- jumbo and Alt-A bonds have rallied more than 10 times only to return to declines, according to JPMorgan Chase & Co. data.

Investing in the bonds is “a big emotional thing: Lots of people have gotten fired and blown up over it,” so assessing the biggest causes of the recent increase is difficult, said Simon, who declined to comment on Newport Beach, California- based Pimco’s holdings and strategy.

George Boyan, head of mortgage-bond trading in New York at Source Capital Group, earlier this month attributed the rally largely to the Fed’s buying of “agency” home-loan bonds under a $1.25 trillion program driving down yields on those securities. Agency mortgage bonds are guaranteed by government- supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae.

Mortgage-Rate Plunge

“Customers who can’t really find the yields they need anymore in the agency space have reached over to the non-agency market,” Boyan said in a telephone interview.

Amherst Securities Group Chief Executive Officer Sean Dobson said the rise in prime-jumbo and Alt-A securities has mainly reflected higher refinancing after a plunge in mortgage rates to record lows. Refinancing has boosted the value of those securities by returning some of the principal of bonds trading below face value at a faster pace.

Dobson, who called that rally “overdone” in an interview, said his Austin, Texas-based firm and the clients it advises have been recently buying subprime-mortgage securities, which along with bonds backed by “option” adjustable-rate mortgages are little changed over the two months, though off lows.

‘Some Healing’

“You’ve seen some healing, you’ve seen risk-taking come back, you’ve seen balance sheets improve,” Simon said. “Just the fact that stock markets are up as much as they are, you’ve recreated a tremendous amount of equity in the world, so I think you’ve started to see people in a position where they can actually put funds to work.”

A change to accounting rules this year that limits the size of writedowns on securities that banks expect to incur losses on also has taken “some pressure off them to sell things, because you could mark them better,” he added.

The $700 billion U.S. Troubled Asset Relief Program would have been a boon for taxpayers if former Treasury Secretary Henry Paulson had gone ahead with plans to buy devalued assets, Simon said. Instead, Paulson used most of the funds to make capital injections into banks.

“If the government had bought $700 billion of supposedly ‘toxic’ assets, they probably would have made $70 billion a year and gotten paid back the $700 billion,” he said, echoing comments he made in an interview before the TARP law was passed.

Pimco Mulls PPIP

Pimco has expressed interest in managing a PPIP fund. Some of the TARP funds are being used in the PPIP and TALF programs for so-called legacy mortgage securities and loans.

Jumbo mortgages are larger than what government-supported mortgage companies Fannie Mae and Freddie Mac can finance, currently from $417,000 in most areas to as much as $729,500. Alt-A mortgages fall between prime and subprime in terms of expected defaults.

The $150 billion Pimco Total Return Fund, the world’s largest fixed-income mutual fund, has returned 6.32 percent over the past five years through May 15, putting it in the top one percent, and 4.92 percent this year, beating 64 percent of competitors. Mortgage- and other asset-backed bonds accounted for 66 percent of its holdings on March 31; that debt is mainly agency home-loan securities.

Bill Gross, Pimco’s co-chief investment officer, manages the fund with input from Simon’s team. The almost $1 billion Pimco Mortgage-Backed Securities Fund that Simon runs himself has returned 5.21 percent over the past five years, better than 73 percent of competitors, and 5.8 percent this year, better than 93 percent of peers.

The hedge fund set up by Pimco at the onset of the credit- market crisis in October 2007 to buy devalued mortgage assets declined 33 percent through the end of 2008, said an investor, who asked not to be identified because the fund is private.