Tuesday, May 28, 2013

Bonds: Approaching the Convexity Vortex

I've mentioned convexity as much in the last quarter as I did in the first five years of the blog and we may be within a few months of seeing why. Or it may just be a meme I picked up.
As to the link from Mr. Krasting I have no idea whether 2.20% is the trigger but I do know there is a trigger
From Bruce Krasting:

Bond Vortex In The Works?
I got an email from a friend who runs money for a hedge fund that got my interest:

may want to take a look at convexity vortex in mbs market and implications…

“Convexity vortex’? What’s that about? A bit more from this fellow, I’ll call him ‘MP’:
Some familiar with it say the vortex is 19 bps away..2.2% on ten year treasury, 3% on the CMM..if breaks, MBS holders subject to extension and duration risk.  Would now have to increase convexity hedging.  Would lead to price gaps and significant selling.  With shortage of treasuries due to bernank and co. and low liquidity, could be very disruptive.
That got me interested. A layman’s explanation of convexity:
When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, AND interest rates rose, the average life of the MBS portfolio would be extended for a few years. This is convexity. The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against “duration risk” by shorting Treasuries (ten-year paper). The higher rates go (and the speed that rates are increasing) forces more and more of the convexity selling.
MP believes that there is a magic number of around 2.2% on the ten-year bond that will bring out an avalanche of convexity selling. The 2.2% tipping point is very close to where the T-bond sits today.
The fellow who brought this to my attention is a perm-bear on bonds. Given that, I sought out a confirmation from another guy (call him JH) who has been bullish on bonds for many years. JH sits on the bond desk of a big international bank. When I posed the question to the Bond Bull I got a surprising response:
I don’t disagree – I would guess we have a huge concentration of mortgages that would go out of the money at 2.25% 10yr UST, slowing prepays, extending servicer portfolios, bringing on longer duration UST selling ……
So there is a vortex risk in front of us. The weaker the ten-year gets (higher yield), the more selling is required. Is the Vortex going to happen? That depends on the performance of the bond market, AND on how the dealer community is positioning themselves against what is a clear Event Risk. The bond bull, JH, had this to say about the probability of a vortex being reached:
in the absence of a real, organic, self-sustaining recovery, I think this all self-corrects – in the medium term anyway, IF it actually gets to that 2.20% range we could see convexity selling..  but in this environment those higher rates won’t sustain..  in fact, I don’t think they even get to 2.20%, but if they do, and convexity selling ensues, and it’s exacerbated by a ‘thin float’ due to the Fed’s presence, it’s temporary and I’d argue a massive buying opportunity
Here are a couple from last week:

Oooh Ooooh: British Sovereign Yields to 1742--Chart
From FT Alphaville:   
Everlasting credit, the long view

From historical chart specialists Global Financial Data — the yield on perpetual Consols versus the stock of UK sovereign debt…all the way back to 1742. Click to view….MORE (chart, discussion)
Unfortunately no discussion of the convexity of an instrument that has this kind of duration. 
Third Avenue - 'The Impact of Higher Interest Rates on Real Estate (When and If It Happens)' And Farmland, What About Farmland