The $1.2 trillion of mortgage-backed securities the Federal Reserve has amassed to stoke economic growth is creating a potential firewall that dealers say is shielding the bond market from a rapid decline as policy makers debate scaling back debt purchases.
The stockpile, which has made the Fed the biggest holder of government-backed mortgage bonds, is cutting the risk that a sudden jump in Treasury yields will lead to an even bigger surge as investors place bearish bets to protect against housing-debt losses triggered by rising rates, a practice known as convexity hedging, according to dealers from Deutsche Bank AG to Barclays Plc. The Fed, which doesn’t hedge, owns about 21 percent of agency mortgage bonds, up from zero a decade ago. The share owned by investors that typically hedge has dropped.
The shift is reducing the odds that the bond market relives 2003, when convexity hedging fueled a 1.45 percentage-point increase in 10-year (USGG10YR) Treasury yields in two months and led to a 4.03 percent loss that July in the Bank of America U.S. Corporate & Government Index, the biggest monthly decline in more than two decades. That index lost 2.07 percent in May, the biggest decline since the 2008 credit crisis, as Treasury yields increased 0.45 percentage point.
“The actual convexity hedging flows will be less when rates rise this time than it was in the past,” Dominic Konstam, the global head of interest-rates research at Deutsche Bank in New York, said in a May 29 telephone interview. 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.”
As rates increase, the expected average lives of mortgage bonds and loan-servicing contracts extend as potential refinancing drops, leaving holders more vulnerable to losses from rising rates. Investors then may seek to pare the duration risk or rebalance existing hedges by selling longer-dated Treasury securities, mortgage bonds or transacting in interest-rate swaps or options on those contracts, sending yields even higher and spreads wider.
The Fed, domestic banks and overseas investors, none of which typically hedge their mortgage holdings, together own almost 65 percent of the outstanding balance of home-loan securities backed by government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae, up from 39 percent in December 2008, according to Nomura Securities International estimates.
Fannie Mae and Freddie Mac’s own holdings of agency mortgage bonds, which they typically hedge in the swaps market, fell to $374.6 billion in April, from $759.2 billion in 2008 and $914.3 billion in 2003. The companies are being forced to shrink their investment portfolios after being seized by the U.S. and are carrying more delinquent and modified whole loans.
While convexity hedging isn’t as large as it once was, it still has been sufficient to contribute to the market’s move during the past few weeks and remains a risk, according to Ohmsatya Ravi, a mortgage-bond analyst in New York at Nomura. Because Wall Street dealers are more cautious after the 2008 financial crisis, even the reduced trading can be significant, he said in a telephone interview yesterday.
“The impact is going to be meaningful because no one is willing to take the other side to the same degree,” Ravi said. “The dealers’ risk-taking propensity and willingness is lower.”
Treasuries yields jumped today on speculation the increase over the past month had triggered convexity-related selling. Yields on the 10-year note rose as much as 0.08 percentage point to 2.29 percent, the highest intraday level since April 2012, and traded at 2.25 percent as of 9:31 a.m. in New York.
It’s the “liquidation of mortgage paper, which needs to be hedged because of convexity fears,” said Thomas di Galoma, senior vice president of fixed-income rates trading at ED&F Man Capital Markets in New York. “That’s where the selling pressure is coming from” today.
Elsewhere in credit markets, the cost to protect against losses on corporate bonds in the U.S. rose for the second day, approaching a two-month high. GM Financial, the unit of General Motors Co. (GM:US) that finances buyers with blemished credit, leads companies planning $4.8 billion of asset-backed bonds. Federal-Mogul Corp. (FDML:US), the auto-parts supplier controlled by billionaire Carl Icahn, is seeking $3.05 billion of debt to refinance.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, increased 2.8 basis points to a mid-price of 86.9 basis points as of 9:26 a.m. in New York, according to prices compiled by Bloomberg. The index reached 88.7 on June 6, the highest intraday level since April 5.
In London, the Markit iTraxx Europe Index, tied to 125 companies with investment-grade ratings, rose 7.7 to 114.
Both indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Bonds of Dearborn, Michigan-based Ford Motor Co. (F:US) are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.8 percent of the volume of dealer trades of $1 million or more, according to data from Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
GM Financial plans to sell $1 billion of securities linked to subprime auto loans, according to people with knowledge of the transaction who asked not to be identified because terms aren’t public. Barclays, Credit Suisse Group AG, Deutsche Bank AG and Morgan Stanley are managing the transaction for the Fort Worth, Texas-based company.
Sales of bonds linked to subprime vehicle debt are climbing, accounting for 13.2 percent of asset-backed issuance this year compared with 10.5 percent in 2012, according to Wells Fargo & Co. Borrowers have sold about $10 billion of the securities to date, analysts at the bank led by John McElravey in Charlotte, North Carolina, wrote in a June 7 report.
Federal-Mogul’s funding will consist of a $1.75 billion term loan, a $550 million revolving credit line and $750 million of senior notes, the company said yesterday in a regulatory filing.
Federal-Mogul had $2.8 billion outstanding under its existing credit pact at the end of March, including a $1.9 billion term loan B due next year and a $950 million term loan C that matures in 2015, according to the filing.
Concern that convexity hedges would accelerate mounted in May as the yield on 10-year Treasuries jumped 0.45 percentage point, the biggest monthly increase since December 2010, amid speculation an improving economy would prompt the Fed to scale back its $85 billion of monthly mortgage and Treasuries purchases. The yield reached 2.23 percent on May 29, the highest since April 2012, before falling back to 2.21 through yesterday.
Yields on one type of mortgage bonds the Fed is buying soared to a one-year high of 142 basis points more than an average of five- and 10-year Treasury rates on June 5, from 114 at the start of May, Bloomberg data show.
Rates for a 30-year home loan rose to 3.91 percent in the week ended June 6, from 3.81 percent, McLean, Virginia-based Freddie Mac said in a statement. That’s up from 3.35 percent at the start of May. The 15-year rate has increased to 3.03 percent from 2.56 percent at the start of last month.
One measure of duration of agency mortgage bonds rose to 4.8 years last week from 3.7 years in April, Barclays index data show. The duration of Fannie Mae (FNMA:US)’s 3.5 percent debt, which is now 6.2 years, would rise to 7.8 years if rates rise 1 percentage point, according to Bloomberg’s prepayment model.
Real estate investment trusts that buy mortgage bonds were one of the biggest drivers of the rise in yields in that market, Ader said. As prices of mortgage bonds fell, eroding a REIT’s net worth, the companies sold bonds to repay loans to reverse rising leverage, according to Mahesh Swaminathan, Credit Suisse’s head of residential mortgage-bond strategy.
“It’s probably the first time we’ve seen this magnitude of adjustment for the REITs,” he said. “Which is why, depending on who you talk to, convexity has been either a big deal or not a big deal.”
REIT holdings of agency mortgage securities have almost quadrupled since 2008 to about $350 billion last year. Their deleveraging sales are more linked to the performance of the bonds relative to hedges, rather than their outright prices, JPMorgan analyst led by Matt Jozoff in New York said in a June 7 report.
Increased volatility in swap spreads during the past month, a gauge of convexity-related hedging, shows some hedging has taken place according to Citigroup Inc. and Nomura. When investors need to reduce duration they sometimes pay fixed rates in swaps, which helps widen the swap spread, or the gap relative to similar-maturity Treasury yields.
The U.S. 10-year interest-rate swap spread rose 0.12 basis points to 20.85 basis points as of 9:25 a.m. in New York, heading for the highest closing level since June 4, 2012. It has climbed from 12.6 basis points on May 21, the day before Fed Chairman Ben S. Bernanke said in congressional testimony that the central bank could consider reducing the $85 billion in monthly Treasury and mortgage debt purchases within “the next few meetings” if officials see signs of sustainable improvement in the labor market.
“The convexity-driven demands are much different than they once were,” with the balance sheets of Fannie Mae and Freddie Mac smaller and the Fed owning many of the most “exceptionally negatively convex assets,” said Jason Callan, head of structured products at Minneapolis-based Columbia Management Investment Advisers LLC, whose firm manages about $167 billion in fixed-income. “There’s definitely been some of that, but I don’t think it’s been anywhere near the magnitude of what it once was,” he said.
The U.S. council of regulators working to strengthen the financial system wrote in April that despite the changes in the structure of the mortgage market it was still ”ambiguous” if the risk of a ”convexity event” was more or less than in 2003. The danger is that it can create “a vicious circle of fire sales that can strain market liquidity,” the Financial Stability Oversight Council wrote in the report.
Mortgage originators’ smaller pipelines of pending loans relative to 2003 is also helping to limit the impact of rising rates, Barclays analysts including Nicholas Strand wrote in a May 31 report. When rates climb after applications, more of the potential borrowers are likely to decide to close on refinancings with the same lenders and no longer shop around, leading to the need to sell forward more mortgage bonds.
Even as rates hover not far from record lows, weekly refinancing applications this year peaked in May at a level that was 48 percent lower than the record high reached in 2003, according to Mortgage Bankers Association data. The difficulty that some borrowers have faced in qualifying for refinancing has also left outstanding mortgages with a wider range of rates, limiting how changes in those available on new loans affect durations across the market, according to Nomura.
‘Half’ the Scale
A 0.5 percentage-point rise in 10-year Treasury yields is likely to trigger mortgage-related hedges that would be the equivalent of about $100 billion sales of the debt, according to Deutsche Bank. That’s about a fifth of the amount of hedging needs in 2003, the Frankfurt-based lender said.
The yield on 10-year Treasuries surged to 4.56 percent in August 2003 from 3.11 percent two months earlier.
Credit Suisse estimates that convexity hedgers sold the equivalent of about $37 billion of 10-year Treasuries amid the past 0.5 percentage-point increase in yields and will sell an additional $48 billion if it were to climb another 0.5 percentage point.
Taken together, the hedging needs of REITs, servicers and Fannie Mae and Freddie Mac produce “probably much less than half of the scale of hedging as in 2003,” Swaminathan said.
“The convexity risk is there, but it is really going to be limited,” said David Ader, head of U.S. government-bond strategy at CRT Capital Group LLC in Stamford, Connecticut, on June 6. “However, the flip side of that is what is potentially driving rates higher is the question if the Fed is going to normalize rates and move out of QE. And we don’t know what that Fed change is worth in the market,” said Ader, who was ranked first by Institutional Investor magazine’s annual survey in government-debt strategy for the seven years ended 2012.
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