(Bloomberg) -- Mortgage bonds have been hit in recent weeks by the US regional bank crisis, and the Federal Reserve has the potential to add to pressure on the securities on Wednesday. 

Excess returns on the bonds, which compares mortgage backed security performance to Treasuries, are -0.94% for March, on track for the worst relative performance since September. Regional lenders including the failed Silicon Valley Bank are widely expected to sell at least some of their holdings to boost their liquidity, which has weighed on the bonds. 

On top of that, it’s unclear what the Federal Reserve’s next move is, as the central bank looks to tame inflation without further destabilizing the financial system. Interest-rate volatility, a measure of uncertainty about the future direction of rates, has surged in March. Any decision the Fed makes on Wednesday that adds to questions about the future direction of rates could hit mortgage bonds, which generally perform worse than Treasuries when volatility is rising.

The US Federal Deposit Insurance Corp. is selling off Silicon Valley Bank after taking it over earlier this month. Some debt traders believe that the bank will look to sell off mortgage bonds to boost its liquidity as soon as this week. 

But even if its portfolio is absorbed into a different bank, any acquirer will be less interested in buying the securities in the future because of its growing holdings, said Erica Adelberg, MBS strategist at Bloomberg Intelligence, in an interview. Either way, future demand for the bonds will suffer. 

“If the portfolio is liquidated or sold to another buyer at a discount, the MBS market will have to absorb the pain of more supply and fewer buyers,” said Adelberg. 

Silicon Valley Bank had around $58 billion of mortgage bonds in a book of securities classified as held-to-maturity as of Dec. 31, about equal to the total supply of new securities in the market February, so its holdings are substantial relative to existing demand, Adelberg said.

The mortgage bond market had already been facing pressure on demand for the securities. The Federal Reserve, until recently the biggest buyer of mortgage bonds, has effectively stopped purchasing them while banks, another key holder of the bonds, have also cut back on their purchases. 

After the SVB collapse, many banks rushed to take advantage of the newly created Bank Term Funding Program, along with regular Federal Reserve discount window borrowing, to get some liquidity, wrote Kirill Krylov and Steven Scheerer, senior portfolio strategists at Robert W. Baird & Co. in a March 20 note. But that funding can be expensive for the institutions, which may feel pressured to sell more. 

With low or no demand from the Fed and banks, there’s only one marginal buyer to snatch up the debt: Money managers. They came in late last year for the bargains, betting the bonds would recover. 

But it’s not clear when they will resume buying. Some investors are hopeful that they’ll step in soon, after spreads on the securities widened by around 0.4 percentage point since early February by one measure, bringing them to their widest since November.    

“The agency MBS market is extremely volatile and there’s a lot of uncertainty stemming from the recent banking crisis and related supply concerns,” said David Goodson, head of securitized credit at Voya Investment Management, in a phone interview. “Despite all the worry, the sector has widened a fair amount and one could argue there is potential for upside.”

--With assistance from Charles Williams.

(Updates with detail on mortgage bond movements in third paragraph)

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