By Richard Beales in New York Published: June 6 2005 20:16 / Last updated: June 6 2005 20:16
If yields on 10-year US Treasuries fall much further, American homeowners will become big players in the Treasury markets. Without buying a single US government bond, they could push Treasury prices up and yields lower still.
The reason: a phenomenon known in the mortgage market as a “convexity grab”. When US homeowners refinance and repay their old mortgages – which they do in droves when interest rates fall low enough – owners of mortgage-backed securities suddenly find that their bonds, which are based on pools of mortgages, are repaid faster than expected.
To offset this, MBS investors are forced to buy long-dated assets such as 10-year Treasuries. That pushes Treasury prices higher and yields down further, encouraging more refinancing. “It becomes a vicious cycle,” said Walter Schmidt, manager of mortgage strategies at FTN Financial.
The effect stems from the unusual structure of the US mortgage market. Homeowners usually borrow for 30 years at a fixed interest rate, set by reference to the yield on 10-year Treasuries. In markets such as the UK, cutting short a fixed-rate loan would cost the borrower money. But in the US, the typical mortgage allows homeowners to refinance at any time without penalty.
Refinancing activity became frenzied in mid-2003 when 30-year mortgage rates fell to about 5.2 per cent, according to the Mortgage Bankers Association. Analysts estimate the next wave of refinancing could come if 30-year mortgage rates fall below about 5.5 per cent. That equates to 10-year Treasury yields of around 3.9 per cent. Treasury yields dipped below that level last week, but then rose towards 4 per cent.
Mortgage refinancing leaves owners of MBS instruments holding cash instead of long-dated bonds. The cash can only be invested at lower yields than the bonds were earning before.
For this reason MBS – unlike most bonds – typically lose value when interest rates fall, and vice versa. Bonds with this characteristic are said to have negative convexity.
Refinancing also disrupts the “duration” of an MBS investor’s portfolio, a function of its yield and the time remaining until the investor expects to be repaid.
As interest rates fall and homeowners refinance their mortgages, duration shortens. Because most investors try to maintain the average duration of their portfolios, they are left scrambling to find safe assets with long duration, such as 10-year Treasuries or interest rate swaps with similar maturity.
About $5,500bn of mortgage-related securities were outstanding at the end of March, compared with about $4,000bn of US Treasury securities, according to the Bond Market Association. The huge volume of mortgage securities helps explain why the technical effect of MBS investors’ “convexity hedging” can exacerbate what begins as a market move based on fundamentals.
Some convexity hedging occurred last week as the yield on the 10-year Treasury reached its lowest point in more than a year. But that activity dried up as Treasury yields widened again.
“It’s been pretty well contained,” said Dale Westhoff, senior managing director at Bear Stearns. He added that the pent-up demand for mortgage refinancing is lower today than it was in 2003.
Refinancing and convexity hedging activity could, however, build if 10-year Treasury yields move below about 3.9 per cent again.
“People really start to get nervous when we go through those levels,” said Mr Westhoff.
For now, MBS investors are waiting on the sidelines. If yields fall, they may need to act. But hedging prematurely could also cause problems. That is because, for MBS investors, rising yields feed on themselves, as homeowners become less likely to refinance their mortgages and investors sell long-dated assets to shorten the duration of their portfolios.
After interest rates hit lows in 2003 and triggered convexity hedging, rates rose sharply. The widening yields caused a new wave of pain to MBS investors, who rushed to sell Treasuries. The market calls this being “whip-sawed”. The memory could be one factor limiting convexity hedging at least until the market decides Treasury yields are set to stay sustainably lower.
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