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Mortgage-Bond Rate Risk Surges Most Since 2010

Christopher Maloney

(Bloomberg) -- The swift move higher in Treasury rates sent mortgage duration, a measure of a bond’s sensitivity to changes in interest rates, to its biggest weekly increase in almost nine years.

The Bloomberg Barclays U.S. MBS index duration rose to 3.11 years from 2.45 years last week, a 27% increase. This was the most violent swing higher in percentage terms since the 47% increase seen during the week ending Sept. 24, 2010, according to data compiled by Bloomberg.

Duration is rising on the assumption that principal payments will be received later than expected, increasing a mortgage bond’s exposure to interest rates during a time when they are increasing. This rise in duration is referred to as extension risk.

Despite the Federal Reserve being expected to continue to cut rates on Wednesday, concern over extension risk may increase further. For mortgage investors who believe the trend of higher interest rates may continue, the shorter amortization profile of 15-year MBS can be one way to protect against extension risk.

During two recent bouts of rising index duration, favoring these bonds over 30-year MBS proved helpful. For example, from Sept. 28, 2016 to Dec. 16, 2016, when index duration rose to 5.1 years from 2.4 years, the Fannie Mae 15-year index performance handily beat the 30-year by 0.80%. During the Dec. 28, 2017 to Feb. 21, 2018 period, when the index duration rose to 5.3 years from 4.43 years, the 15-year also bested 30-year returns, that time by 0.54%.

Specified mortgage bonds -- created using borrower characteristics such as credit cores, loan size or geographic distribution to provide more certainty on when the underlying mortgages will be paid off -- are another way to protect against extension risk, for example by using seasoned pools. Collateralized mortgage obligations can be designed to protect investors during periods of rising rates, too.

While prepayment speeds are forecast to rise about 5% to 10% this month, last week’s move higher in mortgage rates removed about $800 billion conventional borrowers from having any incentive to refinance, according to Brean Capital. So the Refi Wave of 2019 may be over.

On a relative value basis, the option-adjusted spread differential between Fannie Mae 30-year and 15-year current coupon bonds is 2 basis points, well below its trailing 5- and 1-year averages of 13 and 9 basis points, respectively. Last, as 15-year mortgages are primarily created via refinancing of longer amortization mortgages their supply is likely to be muted in a rising rate environment.

Christopher Maloney is a market strategist and former portfolio manager who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

(Updates with definition of duration in first paragraph. A previous version of this story corrected the reference to expected Fed rate move in fourth paragraph)

To contact the reporter on this story: Christopher Maloney in New York at cmaloney16@bloomberg.net

To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Christopher DeReza, Dan Wilchins

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