U.S. mortgage-backed securities risk premiums are about a half-percentage point below where they would be if it were not for massive buying from the Federal Reserve, Amherst Securities said on Tuesday.

The assessment, based on a model by analysts led by Laurie Goodman, provides a basis for estimating adverse reactions in the $5 trillion market when the Fed brings its mortgage bond purchase program to an end, they said in a report.

Expectations that MBS prices will drop as the Fed completes its $1.25 trillion purchase program have increasingly worried investors, many of whom hold a third of their portfolios in the securities to match benchmark indexes. Lower prices on the bonds would also likely translate to higher consumer mortgage rates since lenders originate most loans with intent to sell into the bond market.

Based on a very strong belief that spreads on agency MBS will widen when the Fed stops buying, investors have been seeking out short duration bonds, the analysts said.

Through July, the Fed has purchased $702.1 billion of mortgage bonds issued by government-entities Fannie Mae, Freddie Mac and Ginnie Mae, constituting 241 percent net supply in agency MBS. This demand has lowered the extra yield on the securities over an interest rate benchmark to 1.15 percentage point, versus the modeled 1.61 percentage point absent Fed purchases, they said.

While investors are rightly protecting portfolios with bonds featuring average lives of 1 to 1.5 years, they would probably get better returns by extending to 3 years, where yields are much higher, they said.

It is very tempting to stay short, they said. However, bear in mind that the yield curve is very steep. (Editing by Dan Grebler)

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