Mortgage security hedging and the yield curve - includes article about call and extension risk

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by Julia D. Fernald, Frank Keane, Patricia C. Mosser

The steepening of the yield curve in response to tighter monetary policy this past spring puzzled many market analysts and economists. Most of the explanations of this phenomenon have focused on macroeconomic issues such as market expectations of higher inflation or higher future interest rates. This article offers an additional, markets-based explanation that examines hedging activity--particularly the hedging of mortgage-backed securities--and its effect on the short-run dynamics of the yield curve.

When interest rates rise, both the duration and the expected maturity of a mortgage-backed security (MBS) increase. If market participants seek to counteract the increased price risk in MBSs by taking short positions in similar duration Treasury securities, the increase in MBS duration should cause participants to move their short Treasury positions out the yield curve, effectively increasing the "supply" of long duration Treasuries.

Thus the hedging of mortgage securities in the Treasury market may--in the short run--magnify any increases in long-term rates that accompany policy tightening. To the extent that such hedging activity has become a standard feature of the marketplace in the last few years, it may have permanently altered the short-run dynamics of the yield curve and thus changed the transmission of monetary policy.

RECENT MOVEMENTS IN THE TREASURY YIELD CURVE

Chart 1 highlights several significant movements in the yield curve since the fall of 1993. First, long rates began to rise in October 1993, well before monetary policy tightened. Second, despite little or no observable inflation pressure, the Treasury yield curve did not flatten after policy was tightened: the 125 basis point increase in the federal funds rate from February through May of 1994 was accompanied by a 133 basis point increase in the ten-year Treasury rate. Third, after the change in policy direction in February, the yield curve became more hump-shaped: the two-year Treasury yield rose 175 basis points, but the thirty-year yield increased only 96 basis points.

Although the steepening after February was extreme by historical standards, Cohen and Wenninger (1994) have noted that since the mid-1980s, the short-run responsiveness of long rates to changes in the federal funds rate has increased sharply. A 100 basis point increase in the funds rate caused (on average) only a 15 basis point increase in the ten-year yield in the early 1980s, but a 40 basis point or more increase in the ten-year yield more recently (Chart 2).(1) In other words, when monetary policy is tightened, the yield curve now flattens less. Indeed, in the latest episode, it did not flatten at all.

Interestingly, the change in yield curve dynamics coincided with large-scale structural changes in financial markets, in particular the development of new financial instruments and the widespread securitization of home mortgages.(2) In 1983, less than 20 percent of the stock of residential mortgage debt was securitized; by 1993, nearly 50 percent was securitized. Increased securitization has led to increased use of mark-to-market accounting of mortgage debt, making owners of mortgage assets more sensitive to short-run rate movements.(3) To the extent that mortgage securitization caused quicker adjustments of mortgage portfolios to changing market conditions and thus brought closer links between mortgage and Treasury markets, it may have contributed to the change in yield curve dynamics.

How MBS Hedging Using Treasuries Could Steepen the Yield Curve

When long-term interest rates rise (because of policy tightening or other factors such as higher expected inflation), households, in aggregate, refinance and prepay their mortgages more slowly. For a typical mortgage pool, slower prepayments mean that the future mortgage principal will be repaid more slowly, thus extending the expected maturity of the MBS and increasing its duration. This is extension risk: slower prepayments increase the sensitivity of MBS prices to rising yields (see "Sensitivity of Ten-Year Treasury Yields to Changes in the Federal Funds Rate").

Dealers in MBSs and collateralized mortgage obligations (CMOs) hold inventories of these securities, which they attempt to hedge against such extension risk. One common hedging strategy used by dealers is to offset long MBS positions by taking short positions in combinations of Treasuries that approximate the mortgage security's duration.(4) Thus as rates rise and prepayments fall, dealers must increase the duration of their Treasury hedges to roughly match the increasing duration of their MBS portfolios. For example, a dealer hedging its MBS portfolio with short positions in two- to five-year Treasuries might change to a combination of five- to seven-year Treasuries; a short position in five- to seven-year Treasuries might be changed to a short position in seven- to ten-year securities. (Thirty-year bonds are not generally used to hedge MBSs).

As durations rise and market participants attempt to change their hedges simultaneously, the increase in short positions of long maturity Treasuries should cause their yields to rise by more than the yields of shorter maturity bonds, and the yield curve should steepen. The higher long-term yields could, in turn, reduce refinancing and prepayment rates even further, again increasing MBS duration (and its price sensitivity) and causing additional changes in Treasury hedges. Thus MBS hedging could cause positive feedback or a "multiplier" effect that would further steepen the yield curve.(5)