Many mortgage-bond investors, battered in March by a wave of refinancings, are concerned falling interest rates will prompt another round of homeowners to refinance their loans.

The 30-year mortgage rate has fallen about 20 basis points this month, to 7.03 percent, on expectations that the Federal Reserve will lower borrowing costs for a sixth time this year to boost the economy. The rate is only 20 basis points higher than this year’s low, according to Fannie Mae’s daily loan price.

More Fed cuts may spark “another round of refinancings,” said Dick Waugh, head of fixed-income investments at Principal Capital Income Investors in Des Moines, which has $34 billion in bonds. “We don’t want to get caught in that,” and are holding fewer mortgage bonds than benchmark indexes suggest, he said.

Prepayments on mortgages, which have risen five-fold so far this year, hurt investors in the $2.5 trillion mortgage market by reducing expected interest payments over time. They may also stall a mortgage-bond rally that started in April, when investors bet a low in mortgage rates had been reached.

In one sign of concern that prepayments may speed up, the difference in yield between new-issue mortgage bonds and the 10-year Treasury note has grown by 4 basis points this month to about 146 basis points. It shrank by more than 30 basis points in March and April. Investors demand more in yield to compensate for prepayment risk. The yield difference was more than 180 basis points at the start of the year.

An index measuring refinancing applications at banks, one of the main gauges of coming prepayments, rose 17 percent in the second week of June, according to the Mortgage Bankers Association of America. The index dropped 36 percent, to 1,776, since reaching this year’s peak in the third week of March.

Fed funds futures contracts, which gauge expectations for changes in the central bank’s rate target, indicate traders expect at least a 1/4-point rate cut when policy makers meet in this week, based on the 3.66 percent implied yield on the July contract. Many investors expected a second 1/4-point cut for the Fed’s Aug. 21 meeting, judging from the 3.62 percent implied yield on that month’s contract.

Long-term rates rose through April and May, damping refinancings, as investors bet the Fed was finished lowering rates after dropping its key lending rate between banks by 2 1/2 percentage points this year to boost the anemic economy.

Concern the Fed’s monetary stimulus would spark more inflation also caused bond yields to rise, a fear that will likely grow over the summer.

Inflation concern

As the Fed reduces rates, more “people will become concerned about inflation and long-end rates will remain sticky, including mortgage rates,” said Michael Zazzarino, who helps invest about $29 billion at Brown Brothers Harriman & Co. “Do I think there will be a huge prepayment wave? I don’t think so,” he said.

Still, bonds gained after a government report showed consumer prices excluding food and energy only rise 0.1 percent, compared with the 0.2 percent increase expected by economists.

Recent declines in the swap rate, a fixed rate pegged to the London interbank offered rate that is used as a benchmark for mortgages, has many fretting about triggering a larger push down in rates. The 10-year swap rate has fallen 20 basis points, to about 6 percent this month.

A drop may cause potential losses for mortgage investors since many, in particular hedge funds, arrange to receive fixed-rate swaps to hedge prepayments on mortgage bonds. As they do this, it drives down the swap rate further because of increased demand, which in turn lowers mortgage rates, exacerbating the need to hedge against prepayments.

Hedging risks

A round of such hedging might be triggered if the swap rate sinks another 10 basis points, though a massive hedging need wouldn’t emerge until that rate fell to 5.65 percent, said Alec Crawford, a senior strategist at Morgan Stanley Dean Witter & Co. “We are bullish on rates,” Crawford said. “It’s possible” for the swap rate to fall to that level, he said.

Stuart Sparks, a derivatives strategist at J.P. Morgan Chase & Co., said the 10-year swap rate would have to fall to about 5.80 percent to trigger new hedging from mortgage investors.

Since many investors are now hedging prepayment risk with options on swaps, much of the risk in the mortgage bond market has been shifted to Wall Street, which owns the counterpart in the swap, he said.

If rates would fall enough to trigger those options, known as receiver swaptions, it may put more pressure on rates to fall even further, since Wall Street traders rush to cover the swaptions, lowering forward market rates.