Get Ready for a Bond Rally

 | Oct 30, 2013 | 5:30 PM EDT  | Comments
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Stock quotes in this article:

wfc

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jpm

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gnw

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rdn

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mtg

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spf

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hd

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low

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ll

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whr

In the past six months, the 10-year U.S. Treasury yield surged to about 3% in September from about 1.6% in May, and it has declined to about 2.5% since. Over the next six months I expect the rate to continue its decline, back to the 1.6% range by spring.

Because mortgage spreads for Fannie Mae and Freddie Mac debt have declined during this time (and I expect that to continue), the 30-year fixed conventional conforming mortgage rates should be below 3% at par by spring, which is even lower than in late 2012 and the first half of 2013.

The pent-up demand for housing caused by potential buyers punting purchase decisions following the rate spike of this past summer, combined with record or near-record low mortgage rates in the critical spring/summer housing market, should cause home sales, purchases and prices to rise.

I also expect this to be the strongest housing market, as measured by transactions, in the past decade.

New regulations concerning qualified mortgages, those that may be used to collateralize mortgage-bond securities as determined by the Consumer Financial Protection Bureau and Federal Housing Finance Agency, are due to go into effect Jan. 1, 2014. Although they are indeed much more stringent than they have been for the past 20 years, the majority of this is due to requirements for mortgage applicants to prove income and assets with supporting documents. The fact that the rules are now known will afford lenders the opportunity to become a bit less restrictive with their underwriting.

More importantly, though, the debt-to-income ratios allowed under the new rules are far more lenient than they were 20 years ago. Mortgagors are now allowed to allocate up to 43% of their gross income toward debt service, including a mortgage. To put this in perspective, 20 years ago the maximum allowable percentage of debt a borrower was allowed to allocate toward mortgage payments was 28% of their gross income and total debt service could not exceed 36%.

In real terms, 20 years ago a borrower with a $100,000 gross income could qualify for mortgage payments of $2,333 monthly for Principal, Interest, Taxes and Insurance, or PITI. Mortgage rates were averaging about 8% at the time, which would have allowed for debt service on a $250,000 mortgage.

At a 43% debt service as a percentage of income allowance, that same $100,000 can qualify for a monthly PITI of $3,583. On a 30-year fixed rate of 3% that will service a mortgage balance of up to about $650,000!

I am not advocating that borrowers should leverage themselves to that extent; I'm only noting that the allowance to do so is there.

Lower mortgage rates, higher debt service allowances, known underwriting guidelines, pent-up demand, stabilized housing prices and an incoming dovish Fed chair all indicate that the 2014 purchase market for housing is going to be very strong. This should result in much higher stock prices for names directly related to the residential housing space: mortgage lenders and insurers, homebuilders and building-supply companies. Most of these companies have seen their stock prices trend sideways since the summer spike in rates and concerns about Fed tapering.

In the mortgage sector, Wells Fargo (WFC) will benefit the most because of its dominance of the residential mortgage market. But watch JPMorgan Chase (JPM) -- I'm increasingly convinced that it will not sit back and allow Wells Fargo to run away with the industry.

In the mortgage insurance space, Genworth Financial (GNW) should outperform competitors Radian Group (RDN) and MGIC Investment (MTG) because it is already profitable, whereas the latter two are not.

Among homebuilders, I like Standard Pacific (SPF) because of its concentration on the West Coast. Housing booms over the past 50 years have always started in California and then moved east.

In the supplier and associated markets, I like Home Depot (HD) the most for appreciation because it has trended sideways for the six months. The stock price of Lowe's (LOW) did not pull back during the summer spike in rates and is already reflecting a strong spring /summer 2014 housing market. Lumber Liquidators (LL) has doubled already this year and never pulled back during the summer. Even with a strong housing market, its stock looks overpriced at these levels.

For home appliances, I would go with Whirlpool (WHR).

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