Bond Volatility Approaches Record Low as Fed Drains Convexity
The Federal Reserve’s decision to hold borrowing costs steady into 2015 and buy mortgage debt each month is reducing bond market volatility and demand for options that hedge against changes in interest rates.
Mortgage bond holders often use swaptions, or options on interest-rate swaps, to guard against swings in rates, which can trigger changes in levels of expected mortgage refinancing and the debt’s value. Losses on mortgage debt are greater than on similar maturity and coupon Treasuries when interest rates rise due to so-called negative convexity, which causes the bonds duration, a measure of price sensitivity to interest-rate changes, to simultaneously increase.
Bond market volatility is already approaching the lowest levels since just before the global financial crisis. The fall suggests the $40 billion monthly mortgage purchases and rate guidance announced last week by the Fed may prove to be successful in pushing investors into higher-returning assets, a goal of the central bank as it seeks to spur economic growth and lower unemployment.
“The combination of the strengthened forward rate guidance from the Fed and a new round of quantitative easing is a negative for volatility,” said Ruslan Bikbov, a fixed-income strategist in New York at Bank of America Corp. “The perception of a longer Fed-on-hold and the fact that the central bank is taking negative convexity out of the mortgage-backed securities market will cause volatility to decline.”
Normalized volatility on three-month options for 10-year U.S. interest-rate swaps, known as 3m10y swaptions, fell to as low as 73.9 basis points yesterday, from 83.6 basis points on Sept. 13, the day before the Federal Open Market Committee announced new steps to ease monetary policy. The rate fell in July to the lowest since June 2007. The gauge of volatility on swaptions signals expectations for the pace of fluctuations in swap rates.
In a swap, two parties agree to exchange fixed for variable- rate payments over a set period. Swap rates are higher than Treasury yields because the floating rate payments on a swap are based on interest rates that contain credit risk, such as the London interbank offered rate, or Libor.
The FOMC also said in its statement last week that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens,” heightening speculation that debt purchase and rates will prove prolonged.
Policy makers have kept their target rate for overnight loans between banks in a range of zero to 0.25 percentage point since December 2008. They extended their forward guidance on the level into 2015 from 2014 last week.
Bank of America Merrill Lynch’s MOVE Index, which measures the outlook for the pace of debt price swings based on options, declined to 57.5 basis points yesterday, the least since closing at 56.7 basis points May 7. The index reached a high for the year of 95.40 basis points on June 15. The record low of 51.20 basis points was in May 2007.
Another factor likely to depress volatility is that some of the sellers of the mortgage securities to the Fed may choose to replace the optionality lost in their portfolios in the process, according to Neela Gollapudi, a New York-based strategist at Citigroup Inc.
“The owners of un-hedged MBS positions who give the securities over to the Fed will have to replace it somewhere else,” Gollapudi said in an interview. “If they want to do that in the options market, they would sell swaptions. The likely impact on swaption volatility will not be negligible.”
Normalized volatility on 3y10y swaptions is likely to fall five to seven basis points over the next three months, Gollapudi said. The volatility was 87.8 basis points today, down from 90.75 basis points at the start of the month.
The central bank’s asset purchases “removed a considerable amount of assets with high convexity risk,” wrote Joseph Gagnon, Matthew Raskin, Julie Remache and Brian Sack in a March 2010 Federal Reserve Bank of New York staff report, that concluded the first round of quantitative easing lowered borrowing costs.
The Fed may already be the biggest buyer in the agency mortgage-bond market after starting in October to purchase new securities with proceeds from its past acquisitions of housing- related debt, including $1.25 trillion of home-loan notes through March 2010. It has bought $305 billion of securities under the reinvestment program, which it announced with the first round of its so-called Operation Twist program for Treasuries, where it swaps short- for long-term debt on its portfolio.
Including the existing program in which the Fed is reinvesting proceeds from its past purchase of housing debt into the market, the central bank will be buying about $65 billion to $70 billion a month, according to Bank of America.
“The Fed will be buying mortgages, and they’re not going to hedge out any of the convexity,” Nancy Davis, director of derivatives in New York at AllianceBernstein LP, said in a telephone interview. “That is one reason why rate volatility has been selling off aggressively. The Fed being on hold until 2015 is also volatility damping.”
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