Treasury yields soared and prices correspondingly plunged on June 10th, 2009. The benchmark 10-year note briefly touched the four percent level after the United States Treasury sold $19 billion of 10-year notes and Russia said it would further reduce its share of U.S. debt. This was the highest yield for the benchmark since October 15, 2008 when the credit markets were in the throes of seizure.
During the past few months, Toomre Capital Markets LLC ("TCM") has been quite busy tending to other matters (like client engagements). Hence, Lars Toomre in particular has had limited time to write for this website. However, as often happens behind the scenes, a client contact called to pick Lars' brain about what might be his macro perspective on yesterday's events. That I shared with the client and I also told him a few ways that I would be positioning investment portfolios if I were responsible for the management of fixed-income or equity assets. This client also strongly urged that I also share with the readership of this website a brief write-up about my first statement, which was "It is all about convexity!"
The bond market in general is having fits because of the large amount of Treasury supply that is needed to fund the stimulus package as well as what some regard as the profligate spending of the new Obama administration and Democratic Congress. Hence, Treasury interest rates in general have backed up from the excessively low levels they reached while investors of all types fled to the relative safety of Treasuries. The reader might well remember just a few short months ago that no one wanted to own any type of risky asset.
Both the Treasury and major equity markets are back to levels roughly about where they stood as the events around the bankruptcy of Lehman Brothers and the rescue of AIG took place. Eight months have elapsed during that period. During that period, both equities and bond yields have been much lower. The United States Federal Reserve stepped in with various alphabet soup programs in attempt to maintain some amount of liquidity and to prevent an absolute seizure in the money and credit markets. Hence, the Federal Reserve balance sheet has expanded massively and quite quickly.
While this expansion has occurred, there has been a major move to get consumers with troubled mortgage debt to refinance into more traditional mortgage instruments. Much of that origination occurred at lower interest rates. The resulting securities are now held in large part by either FNMA/FHLM or the Federal Reserve under one of the purchase programs introduced in the last year. Also many of such recently originated mortgage-backed securities are now "under water" or below the origination/purchase cost.
People sometimes forget how much negative convexity there are in mortgage-backed securities, particularly when yields shift by about 150 basis points or more. What start out as securities near par with a duration slightly in excess of four, now become discount securities with durations around six years. (Remember longer durations imply that for a given amount of yield increase, there will be a bigger price drop for a longer duration bond.) The refinance option still residing with the homeowner keeps is far out of the money, and hence the effective duration of the mortgage pool is now much longer. The question is how much longer and what is the over-all consensus in the market about how long that option is going to remain out of the money.