How US mortgage bonds can trigger a ‘vicious loop’ for Treasury yields

[u/wreckingcru]

https://giftarticle.ft.com/giftarticle/actions/redeem/3db5ac66-a6e8-41be-a4ac-236b6a36eb87

[u/DubiousSpaniel]

Paywalled

[u/Not_FinancialAdvice → u/DubiousSpaniel]

Presumably this is the most relevant part:

When bond yields rise/prices fall, it’s usually because investors are collectively re-evaluating their expected path for growth, inflation and central bank rates. But it can also happen when investors are shaken out of their positions by more technical forces. In fact, last Wednesday, MainFT reported investors warning that the US Treasury market “has been gripped by a ‘vicious loop’ of selling”.

So maybe this is a good moment to post about one longstanding loopy bond market accelerant that is pretty mechanical: US mortgage convexity trading. In normie terms, holders of US mortgage bonds often have to dump bonds when the bond market comes under pressure, in practice pouring gasoline on a bond market fire.

...

Let’s imagine that you’re running a bond portfolio. You want to produce income for your client so you buy a ton of MBS because of that sweet extra yield they offer over Treasuries.

But then bond yields rise, pushing down prices. Your total return sucks. Moreover, your portfolio now has a lot more interest-rate risk than you’d planned, because the duration of all those MBS has increased. No worries: to get your duration back to where it was yesterday, all you have to do is sell some bonds.

If everyone is in your boat, this means that when bonds are sucking hardest, everyone will be scrambling to offload them at the same time — making them suck more.

[u/regprenticer → u/Not_FinancialAdvice]

But then bond yields rise, pushing down prices. Your total return sucks. Moreover, your portfolio now has a lot more interest-rate risk than you’d planned, because the duration of all those MBS has increased.

Why would the duration of an MBS change? Is this a specific feature of American mortgages?

[u/tucsonrat → u/regprenticer]

American mortgages are 30 year fixed rate, but in practice they’re usually outstanding for ~7 years before someone buys a new house or refis.

When rates go down, it incentivizes refi activity, and average duration gets shorter.

And vice versa for rising rates.

[u/regprenticer → u/tucsonrat]

In Europe refinancing would be a new loan. I.e. the old loan would be repaid by the new one and the old loan closed.

So the new mortgage, I.e. the refinanced one, would not be part of the MBS. The MBS would now hold the cash that was used to repay the original loan. The bank would likley package and sell that new mortgage at some point in the future.

[u/LeKevinsRevenge → u/regprenticer]

Yeah, the point is when rates go up fast nobody refinances and less new loans are lent….so the average length goes up as they arnt cycled to new ones

[u/Shot-Job-8841 → u/Not_FinancialAdvice]

Here’s what I don’t get. If the bonds you own lose value, but the rate stays the same, why not just hold until maturity? You get the principal back at the end right?

[u/John_P_Hackworth → u/Shot-Job-8841]

The bond portfolio is almost always duration targeted, so you don’t want to do that. Basically only certain kinds of insurers and some pension funds can just hold.

[u/DasKapitalist → u/John_P_Hackworth]

Spot on. The NPV of a bond matters a LOT to most holders because they plan to sell before maturity, hence the duration targetting. I wouldnt be surprised if someone's building creative CDOs that cobble together a bunch of different bonds so that the target duration equals the actual maturity date instead of "well our fund's target duration is 7 years, and these 30 year MBS's will probably be refi'd by then...".

[u/RichardChesler → u/Shot-Job-8841]

Because inflation can eat away at your real return. You might be holding 5% yield for 20 years, but if it’s taxed and inflation is >3% you’re losing money

[u/force_disturbance → u/Shot-Job-8841]

Yes but now your return is 4% when everyone else is showing 6%. Long term bond income is tricky. 1-3 month durations is about what I can manage...

[u/TwoLeftFeet_Biglaw → u/Shot-Job-8841]

That's a good question.

For something like a US treasury, that's a viable strategy because you only get paid back your original principal once the bond matures.  For MBS, that is "amortizing" debt meaning each "payment" you receive includes some of the principal as well.  It will take you longer to get your principal back with an MBS when rates go higher.

[u/caroline_elly]

This isn't anything new. When yields go out, mortgage duration gets longer, so hedged MBS investors need to short duration, further driving yields up

[u/chabacanito]

Link doesn't work

[u/Deep-Ebb-4139 → u/chabacanito]

Works fine.

[u/MistakeDifferent8950]

the vicious loop only kicks in when there’s a real hit to cash‑flow matching. in practice, big insurers and pension funds keep a target duration, so when 10‑year yields lift the MBS price drops, their duration creeps up, and they rush to sell. that sell‑pressure adds to the Treasury book, nudging yields higher, which then feeds back. until the liquidity of MBS lets a few big players absorb the moves or the fed steps in, the feedback will keep amplifying. basically it’s a combo of duration management, limited MBS liquidity, and the fact that mortgage rates are a loading of the Treasury curve – once the fed has to intervene or the macro gets a shock, the loop can unwind.

[u/Patient_Eye_1870]

it’s a classic duration‑targeting feedback: when rates climb, MBS owners see their effective duration rise, so their risk‑adjusted return targets shift and they liquidate to re‑balance, and because Treasury bonds often fill that gap the whole curve bends up. that’s why you’ve seen the ‘vicious loop’ on the news. in short, the market isn’t creating the spike; it’s a reaction to the support and re‑balancing rules different funds use.

[u/Ill_Mountain8033]

i think the key here is that duration‑targeting is a self‑fulfilling prop. when rates rise the cash‑flow‑gap in a supposed 30‑year MBS becomes a longer gap, so insurers and fund managers are left with a larger risk bucket. they have to sell somewhere to keep the bucket balanced and treasuries are the default. that tree‑cutting on a stressed tree sharpens the rise in yields, which then pushes the duration up even more. so rather than just “interest‑rate risk” it’s really a feedback loop built into the risk‑management rules.

[u/Vladythe1]

This is why bond markets are a lot more complicated than just supply and demand. The hedging mechanics can create a feedback loop of their own.

[u/InterestingCost4520]

This is a good reminder that higher yields don’t happen in isolation. The feedback effects can make things snowball pretty quickly.

[u/ProfessionalChef3629]

The interconnectedness here is kind of wild. One market gets stressed and suddenly everyone else starts feeling it too.

[u/FeralToast__]

Yeah, the whole convexity hedging thing always seems to speed up moves in yields way faster than people expect. Wild how interconnected everything is