Halister News

(Bloomberg) -- Convexity risk will remain muted unless the 10Y yield drops to 1.75%-1.80% range and remains there, write BNP Paribas MBS strategists Sarah Hu and Philip Patterson in a research note.

• Chief reason convexity hedging has remained muted is Fed monetary policy has kept rates and volatility “artificially low”
  • Fed is largest owner of agency MBS ($1.7t, ~27% of universe) and doesn’t hedge its holdings
• Prepay risks more driven by policy risks than interest rate risk over recent years
• Ownership profile of MBS universe has switched to entities that don’t hedge such as central banks
  • GSEs, who do hedge, have seen holdings decline
  • Some commercial banks, servicers, REITs, primary dealers do hedge; originators likely don’t need to fully hedge books due to natural hedging created by their pipelines and MSR
    • Investors that hedge hold ~32% of universe, non- hedgers 68%
• Top ten mortgage servicers in 2011 were all banks, by 2015 half were non-bank servicers
  • Non-banks “may not have infrastructure or expertise” to hedge in the same manner as large banks
• Current S-curve flat compared to past levels; 2015 curve flatter than both 2012/2013
  • 100bps ITM FN30 (12-24 WALA) speeds 23 CPR in 2015 vs 25 CPR in 2013, 27 CPR in 2012
    • 50bps OTM speeds were 1-2 CPR faster in 2015 than in 2013/2012
• 4% mortgage rate has 38% of universe at least 50bps ITM, at 3.60% rises to 62%
  • Accounting for credit criteria those numbers are 27%/49%
  • Assuming 30% of investors actively hedge, convexity hedging needs ~$104b in 10Y equivalent for 50bp 10Y rally, ~$50b for 25bp rally
• “Would not be surprising” to see increase in hedging needs as rates rally as MBS tend to be under-hedged in range- bound, low vol. world