NEW YORK (Reuters) - The Federal Reserve's plan for shrinking its massive balance sheet envisions a future with no holdings of mortgage bonds, a prospect that could present a significant headwind for an $8 trillion market the U.S. central bank now dominates.
Mortgages have modestly underperformed a slow-moving bond market this year, and the sector has seen a steady trickle of outflows of investor dollars, but no stampede for the exits. Investors in the sector by and large remain sanguine, and big players are confident the Fed's glacial pace of portfolio normalization - and willingness to resume bond purchases if needed - will limit their downside.
"For now, it simply means that MBS investors should not be concerned about a sudden or drastic change to the Fed's willingness and ability to hold a sizable position of MBS for the foreseeable future and beyond," Walt Schmidt, manager of mortgage research at FTN Financial in Chicago.
Fed officials have signalled they plan soon to begin reducing the bank's $4.24 trillion portfolio of Treasuries and MBS, and market participants expect the process to begin this fall.
Fed officials, including Chair Janet Yellen, have stated a preference for holding only Treasuries in the future, in part to escape criticism that MBS ownership equates to picking winners and losers in markets and the economy.
That means that nearly $1.8 trillion of mortgage bonds, roughly 30 percent of the $6 trillion of securities backed by government-sponsored mortgage companies Fannie Mae, Freddie Mac and Ginnie Mae, could run off the Fed's portfolio over the next decade. It is a delicate manoeuvre that the Fed intends to ease into at a snail's pace.
Abandoning MBS altogether might send mortgage rates soaring and roil the housing market, a critical plank in the economy. So far, though, plans telegraphed by the Fed have produced no sign of disruption even as mortgage interest rates have edged up.
MBS have produced a 1.45 percent total return so far in 2017, lagging the 2.24 percent generated by all investment-grade U.S. debt, according to indexes compiled by Bloomberg and Barclays Capital. .BCUSAMBS .BCUSA
Against that weak performance and the prospect of a slowdown in Fed purchases, some investors might be tempted to bet against the sector, but bond managers at some of the biggest U.S. investment firms caution against it.
"In our view, unless they can size and time short positions perfectly - tough to do - investors are unlikely to make money shorting agency MBS at current levels," according to Daniel Hyman, co-head of agency MBS portfolio management at Newport Beach, California-based PIMCO, which has $1.51 trillion in assets.
Indeed, one measure of underperformance signals MBS are already substantially discounted relative to Treasuries. The spread, or yield premium, on MBS over Treasuries has widened this year, reaching its widest in nearly two years in late June at 33 basis points. It has narrowed modestly since.
So a modest rise in MBS supply on the open market as the Fed buys less should be well absorbed among investors who are seeking low-risk bonds that offer higher yield than Treasuries, fund managers said.
"There's virtually no credit risk and you get a lot more yield," said Bonnie Wongtrakool, portfolio manager at Western Asset Management Co. in Pasadena, California, with $432.7 billion in assets.
When it kicks off the portfolio reduction, the Fed initially plans to slow its MBS purchases by just $4 billion a month and take a year to reach its maximum reduction pace of $20 billion a month, according to plans published recently by the Fed. At that rate, it would take nearly eight years for all of the $1.77 trillion of mortgage securities to roll off.
So far, the Fed's announced intentions have managed to ward off a repeat of the 2013 "taper tantrum" when, with the final QE programme still in full swing, then-Fed Chairman Ben Bernanke surprised markets by signalling the bank was contemplating a reduction of its bond purchases.
Spooked investors dumped bonds, resulting in a widespread spike in mortgage rates and other long-term borrowing costs. MBS spreads shot to levels twice as wide as they are now.
This time, a run of weaker-than-expected U.S. economic data, notably a softening in inflation, have kept a lid on bond yields despite the Fed signalling further rate increases in the coming months.
"We think the balance sheet unwind is fully priced in and don't expect significant market reaction when the Fed starts the process," said Brian Quigley, portfolio manager at the fixed-income group at Malvern, Pennsylvania-based Vanguard which manages $4.4 trillion in assets.
Reporting by Richard Leong; Editing by Dan Burns and Chizu Nomiyama