Mortgage-backed securities (MBS) are securitisations of real estate loan portfolios, most often residential. In the US, they are issued by government agencies (GSE) dedicated to supporting the housing market.1 US MBS are peculiar in that their duration, the sensitivity of the bond price to a change in the yield to maturity, increases when interest rates rise, and vice versa (see Chart 1a). In contrast, the duration of US Treasury bonds moves in the opposite direction to yield changes (see Chart 1b).
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Rising bond yields, convexity hedging and the Federal Reserve
The rise in US government bond yields since the beginning of the year is being closely watched by investors. One reason is the concern that yields will reach a tipping point that will accelerate sales of government bonds, causing a further jump in yields. This risk is related to the USD 9 trillion mortgage-backed securities market. In this Macro Flash Note, GianLuigi Mandruzzato looks at how this risk could evolve and what factors can mitigate it.
Chart 1a. MBS yield and duration
Chart 1b. US 10Y Treasury bond yield and duration
Source: Bloomberg Barclays US MBS Index, Refinitiv and EFGAM calculations.
This feature of US MBS reflects the prepayment option that is peculiar to US mortgage contracts, which allows borrowers to refinance the debt when it is economical to do so. This happens when rates on new mortgages are lower than those set at the signing of the contract. As a result of mortgage refinancing, the duration of outstanding MBS decreases.
Conversely, when mortgage interest rates rise, borrowers have no reason to refinance their debt. From the point of view of MBS investors, the lack of refinancing of the underlying mortgages lengthens the expected time needed to be fully repaid, thereby increasing the duration of the corresponding MBS. Furthermore, the increase in MBS duration will be larger the higher interest rates rise. This feature of MBS is called negative convexity and causes their price to fall more than that of Treasury bonds when yields rise.2
To control this risk within a portfolio, investors can hedge their MBS exposures, for example by buying Treasury bonds, thereby reducing the sensitivity of the portfolio to a rise in market yields. However, due to MBS negative convexity, a large movement in yields makes it necessary to recalibrate the hedging in order to keep the overall duration of the portfolio close to the desired levels. If yields rise, the increase in portfolio duration due to MBS holdings must be offset by selling Treasuries, accentuating the upward trend in government bond yields. Such episodes were observed in 1994 and 2003, coinciding with reversals of US monetary policy, and to a lesser extent during the 2013 taper tantrum.
To assess how high is the risk of another US Treasury selloff triggered by convexity hedging, it is useful to monitor the interest rates on new mortgages, which are typically of 30-year maturity. Data from the Mortgage Bankers Association of America confirm the very close relationship between changes in mortgage interest rates and refinancing activity (see Chart 2). Currently, the rate on new 30-year mortgages is 3.28%, about 40bp lower than a year ago. However, refinancing activity has already decreased in March compared to a year ago and it is very likely to remain weak in the remainder of 2021. As mortgage rates fell until December 2020 to a low of 2.86%, the comparison will not make refinancing economical in the next few quarters. This suggests that the risk of higher Treasury yields due to convexity hedging may intensify.
Chart 2. Mortgage rates and refinancing activity
Source: Mortgage Bankers Association of America, Refinitiv and EFGAM calculations.
The risk of adverse consequences on the government bond market will be mitigated by the reduced importance in the MBS market of investors who intensively hedge convexity risk, such as GSEs, pension funds, insurance companies and REITs (see Chart 3). Notably, the share of GSEs has fallen dramatically since the Great Financial Crisis of 2007-09. Conversely, the share of MBS investors who do not hedge MBS convexity has risen since the launch of the Federal Reserve's Quantitative Easing in 2008. According to data recently released by the Fed, the central bank held almost 24% of the MBS market at the end of 2020. The Fed share of the MBS market will rise further as it purchases USD40 bn of securities per month to combat the pandemic. The share of banks and foreigners, two other categories of investors that do not hedge MBS convexity, has also increased in recent years.
Chart 3. Holdings of US MBS (USD bn)
Source: Federal Reserve Flow of Funds and Bloomberg.
In conclusion, the risk of a violent increase in US government bond yields due to technical factors, such as convexity hedging by MBS investors, appears limited in the near term. However, the recent rise of interest rates on new mortgages indicates that the risk could intensify in the second half of the year and should be closely monitored.
1 There are three main government agencies active in the mortgage market: the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae) and the Government National Mortgage Association (Ginnie Mae). Starting in the 1940s, these entities were introduced by the US Congress to encourage homeownership among the middle and working classes and improve the flow of credit in the housing market while reducing its cost. Freddie Mac and Fannie Mae were bailed out by the government and put into conservatorship after the Great Financial Crisis. Ginnie Mae has always been a federal-owned corporation.
2 Duration can be thought of as the speed at which the price of a bond changes as the yield changes; convexity can then be thought of as the acceleration of the change in the price of the bond as the yield changes.