As the covered bond legislation in the United States sits in committee awaiting an eventual vote in the House of Representatives, traders in Europe – where the product is traditionally based – report that prices are being pushed to "dangerous" levels.

HR 4884, sponsored by Rep. Scott Garrett (R-NJ), would establish a legislative framework for covered bonds in the US. Supporters say its passage is vital to establish a healthy covered bond-trading network that is US-dollar based. Opponents argue that the bonds are too pricey, as dual recourse is required to keep investors shielded from losses. Such a platform, however, could provide origination-funding alternatives to the GSEs and federal home loan banks.

The legislation is currently in referral to the Committee on Financial Services.

Meanwhile in Europe, covered bonds are currently trading close to perspective sovereigns, especially in Germany (the largest market with Pfandbrief), Italy, Portugal and Spain. Traders at Société Générale say that a shortage of supply is pushing Pfandebrief higher.

"In the past week peripheral sovereign bonds corrected, while covered bonds did not correct much," said Soc Gen trading coordinator José Sarafana. "Peripheral covered bonds are trading close to their respective sovereigns." (see chart below)

"Such a constellation has produced underperformance in the past," he added. "We see spread differentials between the two asset classes of the same country of below 20bps as dangerous."

Tim Skeet, the head of the covered bonds at Bank of America Merrill Lynch, is less concerned on the impact of recent activity on the nascent domestic covered bond market. "It is still early days for the US dollar covered bonds and we will need more time and volume before we can usefully talk about trading," he said, "that aside, the US covered bond market is likely to develop further once the vacation period has passed."

Nevertheless, Skeet said that the Pfandbrief market is in parts buoyed by domestic German demand for a product they know and trust, pushing prices higher than a more skeptical international audience might have anticipated. Inevitably German investors place more faith in their own government and financial instruments than even those of neighbors, he added.

Write to Jacob Gaffney.

Bank of America Merrill Lynch recommends investors remain underweight in agency mortgage-backed securities although a widening of the option adjusted spread indicates otherwise.

Chris Flanagan, MBS/ABS strategist at Bank of American Securities, said the "continued bull flattening of the yield curve is the elephant in the room for agency MBS."

Normally a widening of the option adjusted spread "makes the sector appear attractive," but Flanagan said this "does not account for the substantial risk that we are on the cusp of a classic Fed-induced refinancing wave, where the magnitude of the wave once again surprises the MBS market to the upside and mortgages underperform."

And an early indicator of this risk is this week’s break above 4000 in the Mortgage Bankers Association’s refinancing index, according to BofAML.

"Moves higher would be slower and more gradual than in the past, but we think investors should not underestimate the potential to move higher," Flanagan wrote in the firm’s MBS: Securitization Weekly Overview.

Flanagan said with the Fed indicating the current ZIRP rate will remain in place for awhile, any flattening in the yield curve would require "a further, and still major, back-end rally." And "by major, we mean something on the order of at least 100-150 bps," he said.

"While we can think of a few, very good reasons that this scenario might play out," Flanagan wrote. "We need to be clear that we are not making a rate call here. We are simply highlighting this as an asymmetric risk scenario for mortgages."

Write to Jason Philyaw.

Increased liquidity and investor confidence in the commercial real estate sector have led to a threefold increase in defeasance activity during the first half of the year, according to a report from credit rating agency, Moody’s Investors Service.

Moody's said loans originally secured by multi-family properties saw the highest level of defeasance during the first six months, accounting for 46% of total defeasance. Retail properties represented 22% of all defeasance for the period with lodging properties at 17%. And 61% of all defeased loans during the period had two years or less remaining on the loan.

Defeasance activity is when a borrower in a commercial real estate securitization substitutes some type of capital-generating collateral – often Treasury securities – in  lieu of a hard payment.

Analysts at the ratings agency also said the level of defeasance during the first six months is equal to nearly 80% of all defeasance during 2009.

"Although the recent level of defeasance is not expected to significantly improve the credit profile of individual deals, defeasance remains an important factor in CMBS credit because it reduces the inherent risk in commercial real estate loans," Moody's vice president Sandra Ruffin said.

Write to Jason Philyaw.