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Mortgage Hedging Unlikely To Boost Treasury Yields

 February 27, 2013 10:07 AM


(By Mani) The market is abuzz with talk that Treasury yields are nearly high enough to cause a surge in hedging activity as mortgage convexity hedging was a bogeyman for much of the 1990s and 2000s.

However, rising Treasury yields and swap rates could cause mortgage durations to extend, leading mortgage hedgers to enter pay-fixed swaps, which in turn would put more upward pressure on rates.

Conversely, when yields fell, durations would shorten, and hedgers would execute receive-fixed swaps, thereby accelerating the drop in rates.

"Definitely a vicious circle. In our opinion, the bogeyman is not ready to return," UBS strategist Mike Schumacher said in a note to clients.

Convexity, which refers to the inverse relationship between the value of a fixed-income instrument and its yield, helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed.

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When the convexity is high, risk to which the portfolio is exposed also increases and when it becomes vice versa, the bond portfolio can be considered hedged. Investopedia says the higher the coupon rate, the lower the convexity (or market risk) of a bond. This is because market rates would have to increase greatly to surpass the coupon on the bond, meaning there is less risk to the investor.

Mortgages are usually hedged by selling Treasury securities. As a result, interest rate variations coupled with the duration of mortgage backed securities is expected to have a snowball effect on bond rates.

When the duration of an MBS product extends, the market participants try to re-balance hedges by extending their short Treasury positions.

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"Our rule of the thumb is that 10-15% of MBS duration shifts are delta-hedged with interest rate swaps. Consequently, the MBS hedging need this year should approximate selling $30-50 billion 10yr Treasuries," Schumacher noted.

In this scenario, actual re-balancing flows have been far smaller than the theoretical hedging requirement. Some mortgage players could decide to catch up, and initiate substantial transactions.

"We doubt it will happen soon. Furthermore, convexity will continue to moderate if yields increase," Schumacher said.

As a result, the much feared upsurge in mortgage hedging probably will not occur even if Treasury yields rise another 20-30 basis points.

Currently, yields on the benchmark 10-year Treasury bond fell 7 basis points to 1.88 percent. Last Monday, the yield reached 2 percent.

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