Mortgage Investors Cool on Swaps as Rush for Duration Ends

(Bloomberg) -- Investors in mortgage-backed securities are cooling on swaps used to hedge against falling interest rates, signaling confidence that yields may have found their bottom.

The 10-year swap spread has backed off from the tightest level since October 2017, reached last week. The U.S. Treasury 10-year yield had touched a 15-month low of 2.37 percent on March 27.

A U.S. homeowner may prepay their mortgage at will, and the duration of a mortgage-backed security can drop dramatically during periods of falling yields due to the potential for faster prepayments. This means MBS investors need to add duration, referred to as “convexity hedging,” as interest rates drop.

A popular method to add duration is by using swaps and “the 10-year is still the most liquid swap for mortgage hedgers,” said Walt Schmidt, head of mortgage strategies at FTN Financial. Now that the 10-year yield has risen again to the 2.50 percent area, swap spreads are back close to where they lay previous to the rally and “the wave of convexity hedging is likely over for now,” he said.

Duration:  the weighted average maturity of the security’s cash flows, where the present values of the cash flows serve as the weights. The greater the duration of a security, the greater its percentage price volatility.

There are other methods for mortgage investors to add duration, such as buying lower-coupon TBA for their higher duration profile. “Mortgages were pushed a bit too hard through this rally as 3 and 3.5 percent TBA traded in their ‘hedging vehicle’ status for ‘convexity proxies’ in a mad duration grab,” said Russell Middleton, a director on the agency MBS desk at MUFG Securities Americas, Inc.

One thing to keep an eye on is a 4 percent level on the 30-year mortgage rate, according to Schmidt, “due to the big gross weighted-average-coupon buckets between 4.40 and 4.60 percent in outstanding 30-year mortgages.” A drop in the 30-year mortgage rate below 4 percent could reignite a grab for duration.

Mortgage Investors Cool on Swaps as Rush for Duration Ends

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