Mortgage Investors Thrown Off By Rising Yields

Mortgage investors dealing with the fallout of the bad credit mortgage crisis are facing an old nemesis: rising Treasury yields.

In turn, the Treasury market faces increased selling pressure as mortgage loan investors, who typically use U.S. government bonds or interest rate derivatives to hedge against effects of changing mortgage rates, are instead selling Treasuries to counter the impact of higher rates on their investments.

The yield on 10-year U.S. government bonds serves as the benchmark for 30-year fixed-rate mortgages, the most common home loan product.

Last week, mortgage investors pared their Treasuries positions as the yield on 10-year U.S. government bonds seemed poised to hit 5 percent, a level not seen since last summer.

“There’ll be pressure to sell more as yields head up,” said Richard Gordon, fixed-income market strategist at Wachovia.

“This low volatility environment has left some of these players unhedged.”

A sharp rise in U.S. Treasury yields hurts the returns on the $10 trillion worth of residential mortgage loanss and securities outstanding because rising Treasury yields result in higher mortgage rates and make mortgage refinancing less attractive for homeowners.

This phenomenon, known as extension risk, causes a large drop in mortgage prepayments and slower repayments to investors.

Investors often sell Treasuries to counter a spike in extension risk to reduce their duration - or their portfolio’s sensitivity in this case to rising interest rates.

Despite their current spike, Treasury yields remained almost entirely within a narrow band over the past 10 months.

Complacency over this range-trading led some players to decide not pay for hedges against a resurgence in yield volatility or to bet that volatility would fall.

Some players like mortgage companies, which had been banking on yields to hold steady, scrambled to rebalance their portfolios in reaction to the persistent rise in yields, analysts said.

The recent mortgage security selling tied to growing extension risk has intensified the upward pressure on Treasury yields.

Yields have also been rising as more players flock to a booming stock market, on competing supply from the corporate bond sector, and on fading prospects that the Federal Reserve would trim interest rates this year.

“Certainly if we hit 5 percent that will be a major signal for the major mortgage company players to adjust their hedge ratios,” said Fidelio Tata, an interest rate derivatives strategist at RBS Greenwich Capital.

If 10-year Treasury yields were to increase another a quarter point or so from current levels, it could unleash $50 billion 10-year Treasury equivalent worth of hedge selling, according to Tata.

However, some analysts do not expect more mortgage-related selling until Treasury yields shoot much higher.

Continue reading this Reuters article here …