Friday, September 30, 2022 |
||||||||
|---|---|---|---|---|---|---|---|---|
|
MANAGING DIRECTOR: |
||||||||
|
US Treasury Market |
|||||||||||
| Date | 1 mo | 3 mo | 6 mo | 1 yr | 2 yr | 3 yr | 5 yr | 7 yr | 10 yr | 20 yr | 30 yr |
| 09/23/22 | 2.67 | 3.24 | 3.85 | 4.15 | 4.20 | 4.21 | 3.96 | 3.85 | 3.69 | 3.87 | 3.61 |
| 09/26/22 | 2.73 | 3.39 | 3.95 | 4.17 | 4.27 | 4.37 | 4.15 | 4.06 | 3.88 | 4.01 | 3.72 |
| 09/27/22 | 2.71 | 3.35 | 3.91 | 4.16 | 4.30 | 4.39 | 4.21 | 4.14 | 3.97 | 4.15 | 3.87 |
| 09/28/22 | 2.63 | 3.40 | 3.87 | 3.99 | 4.07 | 4.12 | 3.92 | 3.83 | 3.72 | 3.98 | 3.70 |
| 09/29/22 | 2.78 | 3.36 | 3.87 | 3.98 | 4.13 | 4.19 | 3.98 | 3.89 | 3.76 | 4.00 | 3.71 |
Source: U.S. Department of the Treasury, as of 9/29/2022
Negative Convexity – Why Loan Balance Pools
Are Typically Better Than Generic Pools
Are Typically Better Than Generic Pools
Convexity risk is a problem impacting banks and those managing investment portfolios for some time. It is defined as the measurement of sensitivity of a bond’s duration to fluctuation in yield. In simplistic terms convexity attempts to quantify the change in price of a bond with a given change in interest rates.
Bonds can be positively convex: US Treasury notes / bullets / zero coupons or negatively convex: Single family MBS pools, callable USAG, etc. Positive convexity investments tend to move more linearly in equal fashion with moves in overall interest rates. Zero coupon bonds are the most positively convexed bonds. Negatively convex bonds, however do not have a one-for-one price movement due to the embedded options in the underlying security. The easiest example of negatively convex bond is a callable US agency bond. If rates rise, the issuer will typically not refinance the bond and let it go to maturity. However if rates fall and the issuer can save money, they will call the bond and refinance. This puts a cap on the appreciation to the call date.
For single family MBS pools, convexity risk is of paramount importance and often overlooked. For fixed rate MBS pools, three items drive return:
Bonds can be positively convex: US Treasury notes / bullets / zero coupons or negatively convex: Single family MBS pools, callable USAG, etc. Positive convexity investments tend to move more linearly in equal fashion with moves in overall interest rates. Zero coupon bonds are the most positively convexed bonds. Negatively convex bonds, however do not have a one-for-one price movement due to the embedded options in the underlying security. The easiest example of negatively convex bond is a callable US agency bond. If rates rise, the issuer will typically not refinance the bond and let it go to maturity. However if rates fall and the issuer can save money, they will call the bond and refinance. This puts a cap on the appreciation to the call date.
For single family MBS pools, convexity risk is of paramount importance and often overlooked. For fixed rate MBS pools, three items drive return:
- Price
- Coupon
- Prepayments
Both the price and coupon are known when you purchase the bond, however the prepayments are an estimate/guess given the current economic outlook. If rates fall, borrowers are incentivized to refi (prepay) to get a new mortgage at lower rates. If rates rise, they will be less incentivized to prepay early. You will still have prepayments in any rate environment as people move in all markets.
The largest drivers of the refinance decision for a borrower, which is the largest driver of variance in CPRs from projected speeds:
The largest drivers of the refinance decision for a borrower, which is the largest driver of variance in CPRs from projected speeds:
- Mortgage rates
- The size of your loan
The old rule of thumb is that when mortgage rates are lower by 0.75%-1.00% a typical borrower would refinance as the savings with the lower rate will pay for the refinance costs within the first two years. However, the larger the loan size, the less of a move in mortgage rates needed to make a refinance make sense.
The following is an example of the cost savings of a 100bp decrease in mortgage rates for a 150k generic pool. You will note it takes over 3 years for a 150k max borrower to make back the cost of refinancing the mortgage vs the generic pool which recoups its cost in 1.3 years. Rates would have to fall by 2.42% to a mortgage rate of 2.13% for the 150k mortgage borrower to recoup its fees within 1.3 years.
The following is an example of the cost savings of a 100bp decrease in mortgage rates for a 150k generic pool. You will note it takes over 3 years for a 150k max borrower to make back the cost of refinancing the mortgage vs the generic pool which recoups its cost in 1.3 years. Rates would have to fall by 2.42% to a mortgage rate of 2.13% for the 150k mortgage borrower to recoup its fees within 1.3 years.
So why focus on this convexity risk and borrowers incentive to refinance? In rising interest rate environments, we typically see loan balance paper become mispriced or investors solely focused on the base case yield / spread. Why give up 3bps of yield in the base case? We believe because the range of outcomes can be much more dramatic (negatively convex) for generic collateral pools vs loan balance pools. The generic pool both extends more and contracts more than the 150x max (more volatile yield / WAL profile).
If rates fall, we have an above market book yield so we want prepays to be minimal, keeping more of the above average book yield on our books. The 150k max pool contracts to 3.7 WAL vs 2.6 WAL on the generic.
If rates rise, the 150k max only extends to a 6yr WAL vs 6.4 WAL for the generic pool and only 1bps of difference in yield. We are projected to get our money back sooner to reinvest into a higher interest rate environment with the 150k max pool.
When incorporating a range of outcomes we believe the 150k loan balance pool drastically outperforms across shocks. By giving up only 3bps of base case yield you have a much better range of outcomes for your bank’s investment portfolio across shock scenarios.
If rates fall, we have an above market book yield so we want prepays to be minimal, keeping more of the above average book yield on our books. The 150k max pool contracts to 3.7 WAL vs 2.6 WAL on the generic.
If rates rise, the 150k max only extends to a 6yr WAL vs 6.4 WAL for the generic pool and only 1bps of difference in yield. We are projected to get our money back sooner to reinvest into a higher interest rate environment with the 150k max pool.
When incorporating a range of outcomes we believe the 150k loan balance pool drastically outperforms across shocks. By giving up only 3bps of base case yield you have a much better range of outcomes for your bank’s investment portfolio across shock scenarios.
This information is intended for institutional investors only. The material provided in this document/presentation is for informational purposes only and is intended solely for private use. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.
•Not FDIC Insured •No Bank Guarantee •May Lose Value