As rates increase, MBS analysts expect the market's convexity hedging needs to gradually diminish. Servicers are the only group of convexity hedgers that should remain active, MBS analysts report, although this group's convexity needs have always been less compared to originators and investors. Consequently, MBS hedging activity is expected to have less of a near-term impact on fixed-income market interest rate trends.
"Based on changes in the origination environment, a realignment of investor demand, and the current convexity position of the mortgage market, we believe there is a diminished capacity for MBS hedging activity to impact the broader fixed-income markets going forward," Bear Stearns analysts wrote in their most recent Short-Term Prepayment Estimates.
Bear Stearns analysts added that the link between MBS dynamic hedging strategies and interest rates was weakened by two factors: the transition of origination volumes from fixed-rate to ARM products - noting that ARMs made up a record 38% in total agency and non- agency issuance volumes in 2004 - and mortgage assets moving from active hedgers to passive MBS holders.
Bear estimates that this ARM production jump removed roughly 0.27 years of aggregate market duration from the 2004 MBS vintage at current levels. Furthermore, the duration that was moved to ARMs was less likely to be hedged in the fixed-income markets, analysts said, adding that ARMs are typically used as a tool against extension risk. "Therefore, to the extent that fixed rate production shifts to the ARM origination sector, the link between MBS hedging activity and rate moves is weakened," according to Bear Stearns. An example of how ARMs have reduced MBS hedging is the case of the GSEs, who are traditionally one of the most active duration managers in the market. Since fixed rate MBS was rich relative to GSE debt in 2004, the Agencies shifted their purchase commitments to the ARM market where portfolio economics were much more attractive, reports Bear.
Analysts also point to the changing marginal MBS buyer from active hedgers like the GSEs to less aggressive ones like foreign banks and other yield investors. Bear added that the diversification of mortgage assets from one large investor - the GSEs - to multiple buysiders who have different hedging strategies should diffuse the overall hedging activity responding to rate movements. Bear analysts believe that servicers would be most responsive to continued mortgage rate increases especially with industry consolidation and with the pressure to liquidate hedges as 5.5% coupon pricing moves below par.
In a recent report, Countrywide Securities said that servicing would quickly lose a lot of its negative duration in a rising rate scenario that would push the 5.5% coupon below par, adding that servicer needs to sell into declining markets has been a factor in the major price drops that happened in recent years. Although servicers are usually not 100% hedged, in a rising rate environment and as origination volumes decline, servicers' tendency to under-hedge means that it becomes important for them not to own too much duration in a declining market. Countrywide also noted that servicers are also active users of option strategies, which has both positive and negative implications.
Although servicers wouldn't be forced to sell as these puts have helped in reducing unwanted duration in their portfolios, the bad news is that their options counterparties probably would. Countrywide said that the impact of servicer hedge management activities would peak if interest rates increase from here. "A bearish breakout that took the price of 30-year conventional 5.5s below par would compel servicers to sell substantial quantities of duration into a declining bond market," said Countrywide analysts. They added that this has the potential to contribute to an exaggerated downtrade similar to the 2003 and 2004 experience. By contrast, servicer hedges could be comparatively stable if rates fall from this point.
In the near term, however, changes in duration and convexity as rates rise are "a relatively smooth function of interest rates," notes Bear Stearns. With no other large coupons similar to 5.5%s set to roll out of the refi window, analysts think there are currently no rate thresholds expected to result in a sudden duration or convexity shift in mortgages. "Thus we expect mostly incremental changes in the duration and convexity of MBS portfolios in response to further rate increases," analysts said. Another technical element that has mitigated recent extension risk is the flattening yield curve, which lowers implied forward rates thus keeping projected prepays faster and durations less than they would be when assuming a steep curve. Currently, there is also the lack of a heavy mortgage origination pipeline, which contributed to the liquidity crunch in summer 2003, Bear noted.
Other analysts agree that the movement into ARMs is the key component that has reduced the convexity hedging needs of the mortgage market. Although GSEs have shrunk their portfolios, these "are still very large and would still need to be hedged, " said an MBS analyst. GSE portfolios have undergone "significant compositional changes reflective of the compositional changes in the mortgage market as a whole. They are now much more active buyers of subprime MBS and ARMs." These assets experience less dramatic changes in value relative to fixed rates, the analyst said. The problem, he said, is that the MBS market still has very strong memories of what happened in 2003 when there was a dramatic change in mortgage market duration. "That was a one-off case of a whiplash and the market is still over sensitized to that," said the analyst.
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