Bond investors gauge convexity hedging risk as U.S. yields rise

Convexity flows have tapered off since the global financial crisis of 2008 and 2009

  

NEW YORK- 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 hedging", if it's happening at all, is likely on a smaller scale, analysts said, compared to the upswing it caused early this year.

The U.S. Treasury 10-year note yield US10YT=RR has risen roughly 39 basis points since hitting a six-month low of 1.21% in August. This comes within striking distance of the March high at 1.77% as investors priced in higher inflation as well as the potential start in November of the Federal Reserve's tapering of monthly asset purchases.

The U.S. 10-year yield was up 5 basis points at 1.572% on Friday. No one doubts it's headed higher. The 2021 high of 1.77% was hit in late March.

The rise in Treasury yields creates the need for investors who hold mortgage-backed securities (MBS) to reduce the risks on the loans they manage and limit the 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 they're close to 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 said convexity hedging was more dominant, the 10-year yield rose 87 basis points from around 0.90% in early January to the 2021 high of 1.77% hit in March.

When interest rates rise, homeowners do not typically re-finance their mortgages and that limits the flow of prepayments. When prepayments fall, the duration is extended on an MBS because the holder is getting less principal every month.

MBS investors such as insurance companies and real estate investment trusts who need to maintain a certain duration target would have to reduce that 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 floating rate bond has a duration close to zero, while a fixed rate one 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 of the curve to convexity hedging," said David Petrosinelli, managing director and senior trader at broker-dealer InspereX in New York.

"I don't see convexity hedging as bigger in play this time around 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."

Convexity flows have tapered off since the global financial crisis of 2008 and 2009.

The mortgage portfolios of housing government sponsored enterprises Fannie Mae and Freddie Mac, the biggest hedgers 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.

InspereX's Petrosinelli thinks if the 10-year yield gets to 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. That's the highest since June, but down 18 basis points from a 10-month peak hit in April this year.

Analysts said convexity hedging should typically widen longer-dated U.S. swap spreads. U.S. 10-year swaps measure the cost of exchanging fixed-rate cash flows for floating rate ones over a 10-year period.

Unlike now, bouts of convexity hedging early this year 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.

Swap spreads have generally narrowed in recent weeks.

The spread on 10-year U.S. interest rate swaps over Treasuries was last at 0.50 basis points on Friday, less than one-fourth of the spread seen on Sept. 20 when that gap hit 5.25 basis points, the widest since early March 2021.

TD's Goldberg said the recent sell-off has not been out of the ordinary. "In terms of convexity hedging, we're looking at whether the sell-off is orderly or whether it's accelerating. We're not there yet."

(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Diane Craft) ((gertrude.chavez@thomsonreuters.com; 646-301-4124; Reuters Messaging: rm://gertrude.chavez.reuters.com@reuters.net))


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