US bond investors weigh 'convexity' risk in recent Treasury yield decline

Reuters

25-03-2025

NEW YORK, March 25 (Reuters) - The recent drop in U.S. yields has raised speculation that a wave of buying of Treasury securities and derivative products called interest rate swaps by mortgage portfolio managers and insurance companies was partly responsible for their decline.
These purchases are for "convexity" buying that helps offset the effects of mortgage refinancing to take advantage of lower interest rates. They could amplify the decline in Treasury yields that has taken place in recent weeks due to concerns about economic growth.
Convexity is a term describing how small changes in interest rates can have a disproportionate impact on an asset manager's portfolio or an insurer's balance sheet.
Convexity buying looks to have started early this month, as yields slid to the lowest since late October, from 15-month highs in February, analysts said.
The benchmark U.S. 10-year yield , which influences the cost of borrowings on homes, cars, and businesses, has not moved much since bottoming around 4.10% on March 4, after a 56-basis point decline since February 6. But the yield fell 18 bps from March 13 to 4.17% on March 20.
"There's always convexity hedging going on," said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities in New York, citing the amount of uncertainty in markets from mid-January to the end of February and early March.
"It varies in intensity. But it's a large enough move for folks to position their portfolios."
When rates fall, mortgage players including originators, servicers, and investors in mortgage-backed securities (MBS) - insurance companies and real estate investment trusts (REITs) -typically shift hedges on mortgage holdings to balance their portfolios.
Mortgages and MBS allow borrowers to refinance or prepay their loans when rates fall. These prepayments shorten the average life of the mortgage bond, reducing its yield, with the price increasing less than expected when rates fall. This is called "negative convexity" and leaves investors with lower portfolio duration than their benchmark.
While 64% of outstanding mortgages are locked into interest rates below 4%, about 16% have rates above 6%, which could be refinanced quickly when rates fall, Goldman Sachs, in a research note, said.
To keep their portfolio duration in line with their benchmarks, MBS investors will buy either Treasuries, or Treasury futures. They can also buy an interest rate swap, wherein they would receive a fixed rate while paying a floating one, a trade that protects against falling rates.
Investors also hedge against negative MBS convexity by buying so-called "receivers" in the swaptions market, in which the buyer pays a premium for the right to receive a fixed rate on a swap. Analysts said the swaptions market has been skewed toward more receivers, as participants brace for further rate declines.
"There has been a lot of convexity receiving. Investors also want to buy duration because they are concerned lower rates will lead to an imbalance in their portfolios," said Guneet Dhingra, head of U.S. rates strategy at BNP Paribas.
For insurance companies, lower rates could erode profitability for both policyholders and shareholders.
To be sure, active MBS hedgers have dwindled, falling from a peak of 27% of all investors who hold mortgages in their portfolios in 2002 to 6% currently, so the impact of convexity moves is likely limited, Goldman wrote in a research note.
SIGNS OF CONVEXITY HEDGING
Convexity hedging was evident recently in the tightening spread between a 10-year interest rate swap and the 10-year Treasury yield. Tighter swap spreads meant that the differential between the two assets has become more negative, with swap rates falling because of increased demand for fixed-rate payments during bouts of convexity buying.
In fixed-income debt, a rise in price leads to a fall in yield.
U.S. 10-year swap spreads fell to minus 44 bps on Monday from minus 38.30 bps on February 14.
In addition, the short-term implied volatility on longer-dated swaptions such as those on 10-year and 30-year swap rates, has increased. Implied vols of three-month options on 10-year swap rates had risen to a four-month high on March 10 of 27.71 bps, before stabilizing to 25 bps late Monday.
Amrut Nashikkar, managing director and head of derivatives strategy, at Barclays in New York, said volatility in short-dated options such as those with one-year maturities has been elevated given the level of policy uncertainty on trade and tariffs under the Trump administration.
But "expectations of underlying convexity needs may...have caused implied vols to become elevated in longer tenors," he said.