NEW YORK, Oct. 18 Reuters - Bond market investors see increased risk that surging benchmark U.S. Treasury yields could hit or exceed March highs, which could fuel a wave of government debt selling by mortgage portfolio managers and cause rates to spike even further.
But for now, so-called convexity hedge if it's happening at all, is likely on a smaller scale, analysts said, compared to the upward trend it caused early this year.
The yield on 10-year derivative notes has risen roughly 39 basis points since the June low of 1.21% was witnessed in August. This comes within striking distance of the March high at 1.77% as investors priced in higher inflation as well as the possible start in November of the Federal Reserve's tapering of monthly asset purchases.
The U.S. 10-year yield was higher on Friday with 5 basis points being up to 1.572%. No one doubts it is headed higher. The 2021 high of 1.77% was hit in March, late in March.
The rise in Treasury yields creates the need for investors holding mortgage-backed securities MBS to reduce the risks on the loans they manage and limit negative effects of slower loan prepayments when interest rates climb, a move known as convexity hedging We're not at extreme levels yet. Rates have risen and are near 2021 highs, said Gennadiy Goldberg, senior rates strategist, at TD Securities in New York.
If we start breaking through the highs of the year, there could be some concerns about convexity hedging needs. In the first quarter of this year, when traders noted convexity trading was more dominant, the 10 -year yield rose from around 0.90% in January to the 2021 high of 1.77% hit in March.
If interest rates rise, homeowners do not typically refinance their mortgages and that limits the flow of prepayments. When prepayments fall the duration is extended on an MBS because the holder gets less principal every month.
MBS investors such as insurance companies and real estate investment trusts who need to increase the duration target would have to reduce this duration by either selling Treasury Futures or buying interest rate swaps where they would exchange a fixed coupon with another investor for a floating rate bond, a move that effectively cuts the duration of an asset.
A fixed rate bond has a duration close to zero, while a floating rate bond has a longer duration. To reduce duration and comply with portfolio targets, an investor would have to convert the fixed rate bond with a floater.
It's very difficult to assign some theoretical proportion of the sell-off and the steepening in the curve to convexity hedging, says David Petrosinelli, managing director and senior trader at broker-dealer InspereX in New York.
I don't see convexity hedging as in play this time because of the composition of the mortgage market, but also because we have so many factors that should make the curve steeper such as higher inflation and Fed tapering expectations. Since 2008 and 2009, convergence flows have clogged most of the curve since the global financial crisis.
The mortgage portfolios of Housing Government sponsored enterprises, Fannie Mae and Freddie Mac, the biggest hedgers that managing their pre-financial crisis actively managing the duration gap between their assets and liabilities have shrunk.
The Fed holds about 24% of the $10.3 trillion MBS market, but it does not hedge the convexity risk, analysts said.
Petrosinelli thinks if the 15-year yield gets between 1.60% - 1.70%, that could nudge the 30-year primary mortgage rates, the rate borrowers pay, higher and trigger convexity flows.
The U.S. 30-year mortgage rate was 3.18% as of October 8, 31 - year mortgage rate was 3.28% in Vietnam. That's the highest since June, but 18 basis points of a 10 month peak hit in April 2014 from the high in March 2015.
Analysts said that convexity hedging should typically broaden longer-dated U.S. swap spreads. U.S. 10 year swaps measure the cost of exchanging floating rate cash flows for fixed rate ones over a 10 year period
Unlike now, bouts of convexity hedging early this year wider pushed long-tenor spreads about 10 basis points wider.
As portfolios' duration increase, you have demand to pay fixed in swap, which would then bring higher swap rates and wider swap spreads, said Dan Belton, fixed income strategist, at BMO Capital in Chicago.
The spread on 10-year term swaps over Treasuries was last on Friday at 0.50 basis points, less than one-fourth of the spread seen on September 20 when that gap hit 5.25 basis points, the widest since early March 2021.
TD's Goldberg told TCS that the recent sell-off has not been out of the ordinary. In terms of convexity hedging, we look at whether the sell-off is fast or if it's orderly.