Mortgage Bonds Respond to Volatile Week on Wall Street
While risk premiums for agency mortgage bonds increased in the wake of a global flight-to-quality trade on Tuesday, it wasn’t caused by a wave of selling by investors.
Instead, a spike in volatility caused by the dramatic declines in stock prices and bond yields in yesterday’s afternoon trade caused the bulk of the repricing of mortgage bonds that are particularly sensitive to rapid interest rate changes.
This swing highlights the complex nature of mortgage bonds, which unlike Treasuries or traditional U.S. corporate debt, include an option tied to potential home mortgage refinancing.
In trading Wednesday, risk premiums in the $4 trillion agency mortgage bond market have remained stable to slightly tighter versus Treasurys as calm returned to financial markets. The agency mortgage market includes bonds guaranteed by Fannie Mae.
As the stock market plunged and investors across the globe flocked to buy U.S. Treasurys Tuesday, sending the 10-year Treasury yield down to around 4.47 percent, risk premiums for fixed-rate 30-year agency mortgage bonds moved sharply, ending the day 5-8 basis points wider versus Treasurys.
However, the widening had very little to do with outright sales of mortgage bonds, which would have indicated a sudden shift to bearish sentiment among mortgage bond investors. Far from massive selling, there were reasonably balanced “two-way flows” between buyers and sellers.
Rather, the wider risk premiums for mortgage bonds reflected a sharp rise in volatility, meaning the cost of buying options to hedge mortgage loan bond positions was also rising. Generally, when the cost of buying options goes up, mortgage bonds perform less well relative to Treasurys.
U.S. investors, unsure how just low yields would fall, had to quickly assess what lower mortgage rates would mean for homeowner refinancing, which tends to pick up when Treasury yields fall.
When mortgage refinance activity spikes, and thus mortgage loans are paid off early, mortgage bond investors get money returned to them ahead of schedule, and this in a falling rate environment. They then have to reinvest this money for a lower rate of return, which is unattractive.
Using analysis that takes out the effects of higher volatility, or option costs, mortgage bond risk premiums actually moved fairly little yesterday, analysts said, and ended anywhere from flat to 2 basis points wider versus Treasurys.
SOURCE: MarketWatch