Bond investors assess convexity hedge risk as US yields rise

NEW YORK, Oct. 18 (Reuters) – Bond market investors see increased risk that surging US Treasury benchmark yields reach or surpass March highs, which could fuel a wave of government debt sell-offs by managers mortgage portfolios and drive up rates even higher.

But for now, what’s known as “convexity hedging”, if it does occur, is likely on a smaller scale, analysts say, compared to the recovery it sparked earlier this year. .

The yield on 10-year U.S. Treasuries has risen about 39 basis points since hitting a six-month low of 1.21% in August. This stands a striking distance from the March high of 1.77% as investors took into account higher inflation as well as the potential November start of the reduction in monthly asset purchases by the Federal Reserve.

The US 10-year rate rose 5 basis points to 1.572% on Friday. No one doubts that he is going higher. The peak of 1.77% in 2021 was reached at the end of March.

Rising Treasury yields create 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 prepayments when interest rates fall. Interest is climbing, a movement known as “convexity blanket”.

“We are not yet at extreme levels. Rates have gone up and are near 2021 highs, ”said Gennadiy Goldberg, senior rate strategist at TD Securities in New York.

“If we start to break through the highs of the year, there could be concerns about convexity coverage needs.”

In the first quarter of this year, when traders said convex hedging was more dominant, the 10-year yield rose 87 basis points, from around 0.90% in early January to a 2021 high. of 1.77% reached in March.

When interest rates rise, homeowners typically do not refinance their mortgages, limiting the flow of prepayments. When prepayments decrease, the term is extended on an MBS because the holder receives less capital each month.

MBS investors such as insurance companies and REITs who need to maintain a certain target duration should reduce that duration by selling Treasury futures or buying interest rate swaps where they would trade a fixed coupon with another investor against a floating rate bond, a move that effectively shortens the term of an asset.

A floating rate bond has a term close to zero, while a fixed rate bond has a longer term. To reduce the duration and comply with portfolio objectives, an investor should convert the fixed rate bond with a float.

“It’s very difficult to attribute a certain theoretical proportion of the sell-off and the steepening of the curve to the hedging of convexity,” said David Petrosinelli, managing director and senior trader at broker InspereX in New York.

“I don’t think convexity coverage is more important this time around because of the makeup of the mortgage market, but also because we have so many factors that should make the curve steeper, such as higher inflation. high and Fed reduction expectations. “

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

The mortgage portfolios of government-funded housing companies Fannie Mae and Freddie Mac, the largest pre-financial hedges actively managing the term gap between their assets and liabilities, have narrowed.

The Fed owns about 24% of the $ 10.3 trillion MBS market, but it does not cover the risk of convexity, analysts say.

InspereX’s Petrosinelli believes that if the 10-year yield is between 1.60% and 1.70%, it could push 30-year primary mortgage rates, the rate paid by borrowers, higher and trigger cash flows. convexity.

The 30-year US mortgage rate was 3.18% as of October 8. That’s the highest since June, but down 18 basis points from the 10-month high reached in April of this year.

Analysts said convexity hedging should generally widen longer-term U.S. swap spreads. US 10-year swaps measure the cost of swapping fixed rate cash flows for floating rate cash flows over a 10-year period.

Unlike now, the convexity hedging periods at the start of the year widened long-term spreads by about 10 basis points.

“As the duration of the portfolios increases, you have to pay off fixed swaps, which would then result in 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.

On Friday, the spread between 10-year U.S. interest rate swaps and T-bills stood at 0.50 basis points, less than a quarter of the spread seen on September 20 when the spread reached 5.25 basis points, the widest since early March 2021.

Goldberg, of TD, said the recent liquidation was not unusual. “In terms of convexity coverage, we are looking at whether the sale is orderly or if it is accelerating. We are not there yet.