The Convexity Grab

Heady stuff from across the pond: FT looks at the "convexity grab" earlier this week when the 10 year crossed (albeit briefly) below 4%. Since we recently looked at some of the similarities between our two economies (U.K. foreshadowing U.S. Economy), lets have a look at FT’s view’s on our uinterest rates.

Their working thesis is that this could be yet another factor pressuring rates lower:

"If yields on 10-year US Treasuries fall much further, American homeowners will become big players in the Treasury markets. Without buying a single US government bond, they could push Treasury prices up and yields lower still.

The reason: a phenomenon known in the mortgage market as a "convexity grab". When US homeowners refinance and repay their old mortgages – which they do in droves when interest rates fall low enough – owners of mortgage-backed securities suddenly find that their bonds, which are based on pools of mortgages, are repaid faster than expected.

To offset this, MBS investors are forced to buy long-dated assets such as 10-year Treasuries. That pushes Treasury prices higher and yields down further, encouraging more refinancing. "It becomes a vicious cycle," said Walter Schmidt, manager of mortgage strategies at FTN Financial.

The effect stems from the unusual structure of the US mortgage market. Homeowners usually borrow for 30 years at a fixed interest rate, set by reference to the yield on 10-year Treasuries. In markets such as the UK, cutting short a fixed-rate loan would cost the borrower money. But in the US, the typical mortgage allows homeowners to refinance at any time without penalty."

If that’s the case, one would expect a vicious cycle any time rates dropped. But that hasn’t been the experience recently.

In the summer of 2003, when mortgages dropped to 5.1 per cent, we snapped back pretty quickly. With the 10-year Treasury yields hovering around 3.9 % earlier this week, we saw a similar bounce in 30-year mortgage rates — they never fell much below 5.5%

FT suggests that convexity "hedging" has limited further pressure on yields, as fixed income managers anticipate this phenomena and  plan accordingly:

"Mortgage refinancing leaves owners of MBS instruments holding cash
instead of long-dated bonds. The cash can only be invested at lower
yields than the bonds were earning before.

For this reason MBS – unlike most bonds – typically lose value when
interest rates fall, and vice versa. Bonds with this characteristic are
said to have negative convexity.

Refinancing also disrupts the "duration" of an MBS investor’s
portfolio, a function of its yield and the time remaining until the
investor expects to be repaid.

As interest rates fall and homeowners refinance their mortgages,
duration shortens. Because most investors try to maintain the average
duration of their portfolios, they are left scrambling to find safe
assets with long duration, such as 10-year Treasuries or interest rate
swaps with similar maturity."

There are clearly parallels between these two economies, one would imagine the dissimilarity in mortgage refinancing would lead to major behavioral differences. That’s what makes the British conumer behavior, so similar  to the U.S. (as discussed here), so intriguing.

Interesting stuff . . .

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Source:
US mortgages could set off vicious cycle
By Richard Beales in New York
Published: June 6 2005 20:16 | Last updated: June 6 2005 20:16
http://news.ft.com/cms/s/e17b20ae-d6bd-11d9-b0a4-00000e2511c8,ft_acl=,s01=1.html