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By Aleksandrs Rozens and Eric Burroughs
NEW YORK, April 7 (Reuters) - The jolt
to the U.S. bond
market from last week's upbeat jobs report sent interest rates
soaring higher, but where was the much-feared hedging from the
$5.7 trillion mortgage-backed securities market?
Ever since last summer's severe strain from portfolios
holding mortgage-backed securities fueled one of the worst bond
market plunges in the past two decades, investors have fretted
every time Treasury rates jump or fall sharply.
This time around, the 10-year Treasury note yield jumped
higher, climbing nearly 30 basis points on Friday, the biggest
one-day amount in 5-1/2 years. But a few days later, that yield
has recovered and related markets, like those for agency debt
and interest-rate swaps, have settled in a calm.
Market players say mortgage portfolio managers are more
willing to ride out temporary spikes of volatility. By holding
off from hedging until conditions improve, they are not
exacerbating interest rate moves, helping contain any stress.
"Convexity players are getting better and better at hedging
and mitigating their risks. The may not always have the same
influence on the market that many people can expect," said Drew
Matus, chief financial economist at Lehman Brothers.
Still, investors and strategists alike are eyeing potential
trouble if other upbeat economic indicators or statements from
Federal Reserve officials hint of sunnier economic conditions,
which would send official rates higher.
If the Treasury 10-year note yield soars to 4.50 percent or
above, market players expect trouble for a big chunk of the MBS
universe.
The problem is what is known in the market as extension
risk.
When rates rise sharply and quickly, the duration of a
mortgage bond extends much more quickly than investors had
anticipated. That forces them to unwind hedges -- either in
Treasuries, interest-rate swaps or options -- to rebalance the
duration of their bond portfolios.
The jump in U.S. interest rates in recent days means fewer
home owners will refinance their mortgages as readily. This, in
turn, has extended the life of bonds backed by mortgage loans,
hurting mortgage-backed bond prices. The more dramatic the rise
in rates, the more dramatic the extension in the life of a
mortgage bond and the greater the hedging need.
Graig Fantuzzi, head of Morgan Stanley's global
interest-rate strategy team, said the huge jump in rates last
Friday "definitely changes duration profiles that just need to
hedged, and that's unavoidable. It certainly hasn't gone
away."
The 10-year yield now stands at 4.14 percent. But
strategists and swap traders say the real risk for volatility
would come in a move in 10-year yields to 4.50 percent or 4.65
percent. The faster the move in that direction, the greater the
stress on bond markets, they say.
"There is a lot of extension risk between here and 4.50
percent," said Art Frank, head of mortgage strategy at Nomura
Securities International Inc.
A 10-year Treasury yield at 4.50 percent or above would be
the area where mortgage-backed investors would have the most
hedging to do, especially if they hold bonds with coupons of
5.5 percent and 6 percent -- the biggest part of the
mortgage-backed mart, which dwarfs the Treasury market in
size.
"Extension risk in mortgages happens when rates become a
one-way freight train," said Colin Lundgren, portfolio manager
at American Express Asset Management.
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