By Laura Matthews and Gertrude Chavez-Dreyfuss
NEW YORK, Oct 12 (Reuters) – The sharp rise in long-term US Treasury yields has spurred mortgage-related hedging that adds selling pressure to an already strained bond market, though the impact is likely smaller than in past selloffs.
Benchmark 10-year Treasury yields have surged about 130 basis points and 30-year yields have climbed 100 basis points since late February, reflecting a war-driven oil-price spike that has kindled expectations for multiple Federal Reserve rate hikes over the next 12 months.
The rise in yields has pushed 30-year mortgage rates to a nearly three-year high of 7.4%, keeping many homeowners locked into existing loans rather than refinancing as they often do when rates decline.
As rates rise, the expected life of mortgage-backed securities (MBS) extends, a shift that can make them more sensitive to further moves in yields. MBS investors often respond by either selling Treasury futures or by buying interest rate swaps that exchange a fixed coupon for a floating rate, a process known as “convexity hedging” that effectively reduces the duration of an asset.
“The market is carrying a substantial cohort of mortgages originated over the past three years at coupons relatively close to current mortgage rates,” said Mike Riddle, chief executive officer at Eris Innovations, a Chicago-based futures and options products developer.
“If mortgage rates continue to climb and the possibility of further policy tightening remains, the expected duration of those loans can respond meaningfully to the next substantial move in rates,” likely requiring additional hedging — and additional selling pressure in Treasuries.
MBS are pools of thousands of home loans through which investors receive cash flows from homeowners’ monthly principal and interest payments. Because these cash flows are affected by refinancing behavior, their risk profile shifts as interest rates change.
HEDGING ACTIVITY
Evidence of that hedging activity has emerged in recent weeks across rates markets.
By the first week of October, nine megablock trades had been executed in CME-listed Eris swap futures tied to the Secured Overnight Financing Rate (SOFR), each carrying at least $200,000 of exposure to a 1 basis-point move in interest rates, Riddle said. The trades suggested that investors were adjusting positions to reflect shifts in the yield curve.
Daily volume in Eris SOFR Swap Futures hit consecutive records ahead of the Federal Reserve’s September 16 policy meeting, including trades where investors repositioned for an expected rate increase. Open interest, or the number of outstanding contracts that have not been closed, climbed to a record 866,768 contracts on September 21, more than doubling the previous year’s levels.
The activity has drawn attention because convexity hedging has often reinforced bond market selloffs.
The sharp underperformance of MBS and widening of mortgage spreads were also consistent with increased convexity hedging activity, analysts said. If MBS are performing particularly poorly relative to Treasuries at the same time that rates are moving sharply higher, that can be a sign that mortgage investors are hedging.
According to a recent research note from Annaly Capital Management, one of the largest mortgage real estate investment trusts, MBS underperformed Treasuries with comparable duration by 96 basis points in September, their weakest monthly performance since the banking turmoil of March 2023.
MBS spreads to Treasuries also widened by about 13 basis points in September to 125 basis points, signaling that mortgages sold off more than government bonds, according to AGNC Investment Corp.
OUT OF THE MONEY
Still, how much these hedging flows are contributing to the broader rise in yields remains an open question. Analysts say the effect tends to fade as yields rise because more mortgages become locked in, reducing their sensitivity to changes in interest rates.
“More and more of the MBS universe is significantly out of the money, which means they have no refinancing incentive and therefore no prepayment risk, which makes further selloffs less destabilizing,” said Amrut Nashikkar, head of derivatives strategy at Barclays.
Neil Sun, a portfolio manager at BlueBay Asset Management, said that if rates stabilize at their current levels, the biggest selling pressure may be in the rearview mirror.
Beyond cyclical factors, the mortgage market itself is no longer large enough to exert the same influence on Treasury yields it once did, analysts said.
James Wang, head of macro at US Bank, said the mortgage market is much smaller than the one that amplified bond market swings before the 2008 financial crisis.
The mortgage portfolios of the government-sponsored housing enterprises Fannie Mae and Freddie Mac have contracted significantly since the crisis. Fannie and Freddie were the biggest hedgers pre-crisis because they actively managed the duration gap, reflecting interest-rate risk, between their assets and liabilities.
“At the end of the day, monetary policy expectations are the No. 1 driver of the selloff,” Wang said.
(Reporting by Laura Matthews and Gertrude Chavez-Dreyfuss in New York; Additional reporting by Suzanne McGee in Rhode Island; Editing by Colin Barr and Andrea Ricci )
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