The $8 trillion mortgage market can trigger big swings across fixed income when the Federal Reserve shifts interest rates, but investors say this time is different.
For decades, hedging of mortgage debt has been a key force to watch as the Fed eased policy, with the potential to turbocharge rallies across Treasuries, causing yields to spiral lower. This time around, the mortgage market is more of a sleeping giant, and some investors see that as a reason fixed-income turbulence will ebb.
Over half of US homeowners locked in super low-rate mortgages when borrowing costs reached historic lows during the pandemic. So even if the Fed reduces rates by two percentage points from here, it wouldn’t be enough to spur a significant wave of refinancing, according to Bank of America Corp. That diminishes MBS portfolio managers’ need to hedge their holdings, which they often do by buying Treasuries.
“The lock-in effect is pretty big this time,” said Vineer Bhansali, founder of asset manager LongTail Alpha, whose career included stints at Salomon Brothers in its fixed-income arbitrage group, and at Pacific Investment Management Co.
He expects the 10-year Treasury yield, now at roughly 3.65%, to move between around 3.25% and 4.25%. And with bond-market fluctuations still elevated relative to pre-pandemic levels, the slim chance of a big mortgage-hedging wave kicking in is emboldening him to use long-term options to wager that volatility will fall.
Typically when interest rates decline, MBS investors receive more prepayments as homeowners refinance, causing the duration of their portfolios to decline. Anticipating this, some money managers hedge their mortgage debt by purchasing bonds including Treasuries, or using derivatives offering similar exposure. The reverse is also true: When rates rise, MBS investors will sell long-term Treasuries to keep duration from extending.
Overall, the effect of these measures — known as convexity hedging — is to exacerbate moves in Treasury yields, by adding to the buying when prices are rising, and magnifying the selling when prices are falling.
In 2003, for example, convexity hedging contributed to losses in Treasuries as benchmark yields surged roughly 1.5 percentage points in two months. Convexity was also in play in 2019, as worries about a possible recession built and the Fed was getting closer to starting an easing cycle mid-year.
But now, that effect looks to be muted. Some 64% of single-family mortgages have interest rates of roughly 4% or lower, according to Richard Estabrook, a strategist at Oppenheimer & Co., well below current 30-year mortgage rates of around 6.2%.
The vast majority of mortgage bonds owned by the Fed — some of which are slowly rolling off its balance sheet as part of its quantitative-tightening program — also carry low rates. So there’s scant risk that the central bank, which must redeploy any MBS paydowns above a certain cap into Treasuries, will be on the receiving end of a big prepayment wave anytime soon.
“These sources of demand we were accustomed to seeing over the last 25 years aren’t going to be there now as conditions have changed,” said Chris Ahrens, a strategist at Stifel Nicolaus & Co.
Less Hedging
There’s also been a general decline in hedging of MBS. Since 2002, the share of MBS owned by investors who tend to actively hedge their portfolios — including Fannie Mae and Freddie Mac — has dropped to 6% from 27%, according to a Goldman Sachs Group Inc. note this month.
The two government-sponsored enterprises in particular — Fannie and Freddie — were active hedgers because their MBS ownership used to be far larger. But after 2008 they began shedding those holdings. And the Fed still holds more than $2 trillion of mortgages purchased as part of emergency measures during the pandemic, and it doesn’t hedge its duration risk.
To be sure, money managers have been buying plenty of high-coupon MBS over the last couple years and at least some will look to hedge those holdings, said Priya Misra, a portfolio manager at JPMorgan Asset Management. But those holdings still represent only a small share of the overall market.
Traders anticipate the Fed will lower rates by at least a quarter-point on Wednesday as it pulls back from the tightest monetary policy in decades, and decrease rates by more than two percentage points in total by mid-2025.
Even if mortgage rates dropped to 4.5%, that would only make about 20% of the market “truly in the money to refinance,” Bank of America strategists wrote in a report last month. When mortgage rates were around 6.5%, that refinanceable portion was about 4%, they said.
“When rates are rallying, this inherent demand to hedge MBS acts as an accelerant,” said Meghan Swiber, a strategist at Bank of America. “You shouldn’t expect to see much of that happen with 10-year rates above 3%.”
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