An oldie but goodie. Originally posted March 24, 2014:
It appears our May 2013 post "Bonds: Approaching the Convexity Vortex" may have been unduly pessimistic.
(or, as Ben 'Bhagavad Gita' Bernanke might have said: "I am become Markets, the destroyer of worlds")
p.s. I know it's a mistranslation, please don't write, especially in sanskrit.
From the Federal Reserve Bank of New York's Liberty Street Economics blog:
The rise in the ten-year Treasury rate last summer was perhaps the most dramatic since the 2003 bond market sell-off. This post explains how major changes in the composition of agency mortgage-backed securities (MBS) ownership caused by the large-scale asset purchase programs (LSAPs) may have prevented a major convexity event triggered by MBS duration extension hedging. In fact, MBS hedging activity remained muted by historic standards and likely contributed only modestly to the rise in interest rates.But then again, maybe we knew all that by June '13's "Fed’s securities purchases blunt the impact of convexity hedging" and Ben is actually the God of love, Kāmadeva.
Extension Risk
Historically, the risk of sudden yield curve movements has greatly affected the market for MBS, which represent claims on a pool of underlying residential mortgages. The interest rate risk of MBS differs from the interest rate risk of Treasury securities because of the embedded prepayment option in conventional residential mortgages that allows homeowners to refinance their mortgages when it is economical to do so: When interest rates fall, homeowners tend to refinance their existing loans into new lower-rate mortgages, thereby increasing prepayments and depriving MBS investors of the higher coupon income. However, when rates rise, refinancing activity tends to decline and prepayments fall, thereby extending the period of time MBS investors receive below-market rate returns on their investment. This is commonly known as “extension risk” in MBS markets.
Duration and Convexity
The effect of the prepayment option can be seen in the chart below, which displays the relationship between yield changes (x-axis) and changes in the value of an MBS (black) and a non-prepayable ten-year Treasury note (red). The sensitivity of each instrument to small changes in yields (essentially the slope of each yield-price relationship at the point at which the MBS was last hedged, indicated by the dashed line) is known as the effective duration, while the rate at which duration changes as yields change (the curvature of the price-yield relationship) is known as its convexity. In the example shown below, the MBS and Treasury security are duration matched in the sense that they will tend to move one-to-one for small changes in yields.
When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances....MORE
