Convexity Hedging Increases Risk in US Markets

Convexity Hedging Increases Risk in US Markets

If you have been watching the yield curve for U.S. treasuries, you will have noticed a rise in interest rates pretty much across the board.

As Treasury yields go north, so do mortgage rates. In fact, those have risen by 76 basis points in about a month.

30 year, 15 year and 5/1 Adjustable Rate Mortgages

The obvious corollary of this development is that mortgage refinancing tumbles, and seeing as all this is happening against a backdrop of no growth/low growth, losses are likely to mount. With suppressed opportunities for refinancing mortgages and other loan servicing, security duration increases and holders are exposed to risk. To mitigate the risk, investors may seek to sell longer-dated Treasuries and mortgage bonds, or alternatively to make interest rate swaps or options on their bonds, putting further upwards pressure on yields and increasing spreads. In other words, convexity hedging will increase; the only question is by how much.

According to Dominic Konstam, global head of interest rates research at Deutsche Bank, “the actual convexity hedging flows will be less when rates rise this time than it was in the past. The hedging was massive in 2003, and we won’t see a repeat of that. With the Fed holding so much of the mortgage paper, it really knocks down the amount of mortgage hedging needed when yields rise.”

Although convexity hedging is likely to ‘be less’ than in 2003, there is definitely an effect to be expected as bond rates increase. Dismissing the inherent risk is overestimating the power of the Fed, not to mention missing the channel via which convexity hedging is most prevalent: Mortgage-backed securities.

Convexity hedging affects mortgage-backed securities most of all asset classes, and poses certain challenges, seeing as these bonds exhibit negative convexity, meaning that ceteris paribus, an increase in the interest rate, such as what has been observed for U.S. Treasuries, will lengthen the bond as prepayments slow down and vice versa; when interest rates decrease, prepayment accelerates on high-coupon mortgages and shortens the bond. Since interest rates have been decreasing over the past couple of years in response to monetary stimulus, the new, lower-coupon bonds come with a lot more convexity, which is why even the modest increase in U.S. Treasuries has made some investors and observers of the market call for caution.

The conundrum is premised on the assumption that Treasuries rates will increase, which prompts the question: Will they? According to Jim O’Neill, former chairman of Goldman Sachs Asset Management, the answer is yes. O’Neill is of the opinion that the U.S. economy is returning to normalcy, and the Fed will have to adjust their policies sooner or later accordingly – probably sooner. Investors “better get used to US bond yields near 4 percent rather than 2 percent.”

During May, 10-year note yields went up by 46 basis-points amid increasing speculation that the Fed, largest holder of Treasuries with $1.89 trillion, may begin to scale back its bond buying. 46 basis-points constitutes the biggest jump since a 50 basis-point advance in December 2010. According to estimates from a recent Bloomberg survey among economists, it is expected that the Fed will reduce its purchases to $65 billion a month at its October meeting, thus arguably instigating an increase in interest rates.

The irony of this story is that the cause for concern is an improving U.S. economy. That goes to show why convexity hedging in the mortgage market matters, and how there are far more unintended consequences attached to interest rate manipulation as we have witnessed since the credit crunch in 2008.

Categories: Finance, North America

About Author

Mikala Sorenson

Mikala Sorensen is an Economist with regional expertise in Europe. She holds a first class honours degree in Philosophy, Politics and Economics from the University of York and a Masters in Economics from the University of Copenhagen. Having interned at the Danish OECD-delegation in Paris and currently working at the Danish Ministry of Finance, she specialises in politics and macroeconomics. Analysis for GRI is an expression of her own views.