Steven J. Luttrell, Managing Director, Drake Management LLC, assesses the real impact of the growth in the US mortgage-backed securities market and outlines the implications for fixed income hedge fund managers.
At the start of 2003, Wall Street economists were almost uniform in their forecast: the US 10-year note yield would end the year at 5.0% as the benchmark rate in the benchmark market gradually trended upward on the back of improving economic data.
Buoyed by tremendous monetary and fiscal stimulus, a big Republican tax break, and the great mortgage refinancing boom, who would have thought that interest rates would gyrate wildly and that US agencies Freddie Mac and Fannie Mae, in an effort to hedge their outsized mortgage holdings, would again usher in a spectacular summer storm?
Certainly not many fixed income hedge fund managers, who fastidiously study the market's every move in an attempt to discern attractive risk and return opportunities. But every new financial market weather pattern must be charted, so the question remains: What is the real impact of the growth in the US mortgage-backed securities, or MBS, market and how should investment managers prepare for the next year's 100-year flood?
World interest rates have been on a roller-coaster ride since May of this year, when U.S. Federal Reserve Chairman Alan Greenspan announced his concern about declining inflation. The statement sparked a rally in U.S. Treasury bonds that pushed 10-year yields down to a 45-year low of almost 3 percent. But the realization in late June that the Fed was less concerned about deflation than market players thought, and was unlikely to employ unconventional measures to combat it, ignited a massive sell-off that pushed the 10-year yield back above 4.5 percent by the end of July.
Incredibly, during July, the benchmark 10-year note sustained its worst monthly sell-off since its introduction. Amidst the highly correlated volatility in the United States and Europe, Japanese government bond yields also surprised market participants by climbing well over 100 basis points (bps) with astonishing speed. The late summer months were characterized by widespread liquidation of broadly held positions and fears of potential systemic event risk caused by the violent rise in yields.
The swiftness with which government bond yields rose impaired high-grade spread sectors and derivative markets alike. For example, in July MBS had their worst month since March 1994 as the unprecedented surge in government bond yields sparked heavy selling with half of the total spread expansion occurring on the very last day of the month. Ten-year interest rate swaps in the United States, which reflect high-grade corporate risk premiums and overall bond market volatility, gapped 35 basis points wider. Such a move had not been witnessed since the bond market calamity in the fall of 1998.
To further illustrate the rapidity of the price action, as highlighted in the schematic depicted, half of the month's total change in swap spreads occurred in the last four trading sessions. Some investors and traders blame the turmoil on poor communication by the Fed's policy-setting committee, but officials said that the improving economic outlook and mortgage hedging were larger factors.
As bond yields continue to whipsaw in October, the specter of mortgage hedging looms large over the bond market. The growth of the residential mortgage market has been remarkable, with the amount of outstanding mortgage-related debt expanding by an average of more that 10 percent per year since 1998, according to economists Roberto Perli and Brian Sack in a recent study commissioned by the Fed Board of Governors in Washington. At over USD 4 trillion, today mortgage-backed issues comprise the single largest sector of the bond market, representing over a third of all marketable debt traded in the United States.
Mortgage-backed securities differ from most other categories of debt in that they are subject to the risk of prepayment. Almost all residential mortgages underwritten in the United States provide the homeowner with the right to prepay the face value of the loan without penalty. For the MBS holder, this is referred to as "negative convexity" given the propensity for these securities to underperform comparable maturity, non-callable bonds in large rallies and sell-offs. Reflecting the downward trend in interest rates, the lower cost and increased efficiency of the refinancing process, the risk of prepayment has been an important concern to the holder of the mortgage-related debt in recent years.
In general, mortgage-backed securities are held by a variety of investors, although there are several large participants in the market. Fannie Mae and Freddie Mac are the two largest mortgage holders. Other large MBS holders are commercial banks, which are attracted by their superior yields and little or no credit risk.
Owners of mortgage-backed securities often must buy Treasury bonds or make equivalent investments in derivatives when interest rates are falling, to try and hedge the impact on their portfolios. Since bond yields move in the opposite direction to prices, such hedging tends to push rates even lower. Conversely, when rates rise, mortgage holders tend to sell bonds, pushing rates even higher.
"The results indicate that these effects are statistically significant and considerable in magnitude, with recent amplification levels of between 16 and 30 percent," wrote Perli and Sack. That implies that a rise or fall in market interest rates of 1.0 percentage point could turn into a move of between 1.16 and 1.30 percentage points after mortgage investors hedged against the initial move. Further to the point, the sheer size of the mortgage market implies that efforts to hedge the prepayment risk of those securities can result in sizable shifts in the demand for other fixed-income securities.
The summer of 2003 is going to stand as the benchmark period to examine the potential impact of mortgage hedging activity on the fixed income market. During this period, as the option-adjusted duration of the Lehman MBS Index lengthened by over two years in response to a better than 75 bps increase in mortgage rates, mortgage convexity players were forced into the market to sell duration. Since most of this rebalancing was done through paying the fixed side of the interest rate swap market, swaps spread differentials expanded markedly, as previously highlighted.
According to Lehman Brothers, in an extrapolation from that experience, we should expect three main effects of mortgage convexity hedging in greater than 50 bps sell-offs [and vice versa in rallies]:
* Increased volatility in overall interest rates due to convexity hedging;
* Yield curve steepening as duration extension is more pronounced at the long-end;
* Increase in implied volatility, with greater demand for high strike options.
Learning from the recent carnage, it is essential to recognize the growth and impact of the mortgage-backed securities market. In order to properly gauge the technicals of supply and demand in fast-moving periods, fixed income professionals need to better understand how mortgage-hedging activity can amplify movements in long-term interest rates.
True, mortgage convexity risk does not cause interest rates to move. It simply exacerbates any sudden yield curve movements stemming from economic data releases and other news shocks. But having an estimate of the extent to which the volatility of interest rate movements respond to mortgage hedging activity is crucial for determining the anticipated costs of dynamic hedging strategies. Importantly, the results have implications for the risks of a much wider set of assets whose values depend either directly or indirectly on long-term interest rates.
Based in New York, Drake Management was founded in May 2001 and is an SEC Registered Investment Adviser. The founders worked together at both PIMCO and BlackRock prior to starting Drake. Presently, the firm employs 30 professionals and manages approximately USD 1 billion across two global, multi-strategy hedge funds and traditional fixed income portfolios for institutional investors.
copyright hedgeweek 2003