Increasing Rates Are Causing Dislocations In MBS Securities

I read an interesting piece Wednesday on Bloomberg’s site that provided some interesting information with regard to the movement of rates and the shifting of bond durations.

Duration represents risk to bond portfolios. The longer the duration of the portfolio, the higher the volatility of the price movement, given a change of X% in rates. With MBS’s (mortgage backed securities) a funny thing happens when rates go up. The duration of the portfolios extend. Why? As the rates move higher, it’s less likely that the homeowner is going to re-finance his debt. Why would he want to re-fi into a higher rate? He won’t refi. That makes the MBS’s duration extend further into the future. Essentially a 10 year bond now becomes a 15 year bond.

When this takes place, the portfolio manager has to shorten the duration to get it back to where he/she wants it to be. This is done by reducing the quantity of longer dated Treasury bonds. So he sells the Treasury bonds, effectively reducing the duration of the portfolio. A side effect of this is that it depresses prices and raises yields even further. As yields move higher, it causes duration to extend, and the manager is forced to sell yet even more Treasuries. It turns into a bit of a rate spiral, with rates spiraling higher. The following chart shows how the rate on the 10 year Treasury has moved from 2% to 3.5% since last December. That’s a big move for the 10 year Treasury Bond.

The following chart shows the increasing purchases by the FED of Mortgage Backed Securities. The purchases are being made to help keep mortgage rates low. Higher mortgage rates will slow the “recovery” (quotation marks..for sure).

Even with the purchases, mortgage rates are continuing to move higher.

Bloomberg article suggests the following:

Lengthening DurationsAs rates increase, the projected average lives of mortgage bonds and loan-servicing contracts extend as estimated refinancing drops, leaving holders with portfolios of longer- than-anticipated durations. Investors then may seek to pare durations by selling longer-dated Treasury securities, mortgage bonds and interest-rate swaps, sending yields even higher.A further 0.25 percentage-point increase in loan rates will extend the durations of 30-year agency mortgage securities by the equivalent of $149 billion of 10-year Treasuries, the strategists wrote. Contracts in the entire loan-servicing market, where holders are even more apt to “actively hedge,” will extend by about $17 billion to $19 billion, they wrote.

Asked today whether the Fed would need to buy the entire $1.25 trillion it now describes as the limit for its mortgage- bond holdings, Chairman Ben S. Bernanke told lawmakers that the Federal Open Market Committee, which next meets June 24, would “evaluate the state of the economy, the state of the market and credit markets in general and we will make that decision.”

Job LossesEconomists project a Labor Department report in two days will show the unemployment rate in May topped 9 percent for the first time in more than 25 years and payrolls probably fell by more than 500,000 workers, according to a Bloomberg survey.An inability by consumers to sustain gains in spending on concern over rising unemployment is among reasons the next expansion will probably be subdued. The economy has lost 5.7 million jobs since the recession began in December 2007, the worst performance of any post-World War II downturn.

The ISM non-manufacturing industries index of employment rose to 39 from 37 the prior month, and its gauge of new orders fell to 44.4 from 47.