By Gertrude Chavez-Dreyfuss
NEW YORK, May 21 (Reuters) – Surging U.S. Treasury yields have prompted mortgage investors to hedge the loans in their portfolios by selling government debt, a shift that probably exacerbated the bond selloff this week and added to the biggest rate spike in a year.
U.S. yields have climbed since higher-than-expected inflation reports for April prompted investors to expect the Federal Reserve will hike interest rates this year instead of cutting them. The benchmark 10-year yield advanced 23 basis points in a week, and now it is up more than 60 bps since the beginning of the U.S.-Israeli war on Iran.
Higher yields have increased the need for investors holding mortgage-backed securities (MBS) to reduce risks on the loans they manage. That process, known as “convexity hedging,” aims to counter the negative effects of slower loan prepayments when interest rates climb.
“The velocity of the move in yields has been concerning and we have seen some forced selling because of convexity hedging,” said Vishal Khanduja, head of the broad markets fixed income team at Morgan Stanley Investment Management in Boston.
The 10-year yield was last at 4.62%. On Tuesday, it hit 4.69%, its highest since January 2025. On that day, the five-year yield rose to 4.35%, a 15-month peak. These are two maturities in which convexity typically occurs.
THE IMPACT OF REFINANCING
Mortgage-backed securities are pools of thousands of home loans through which investors receive cash flows from homeowners’ monthly principal and interest payments. Because these cash flows depend in part on refinancing behavior, their risk profile shifts as interest rates change, making hedging essential.
Rising rates generally give homeowners less incentive to refinance their mortgages, reducing the flow of prepayments in MBS portfolios. As prepayments slow, the duration of these securities extends because investors receive less principal repayment each month. Duration, expressed in years to maturity, measures how sensitive a bond’s price is to changes in interest rates.
This relationship between interest rates, duration and price movements is also influenced by a bond’s convexity. Most bonds exhibit positive convexity; when Treasury yields fall, bond prices rise faster. When rates go up, prices fall — but at a slower pace.
Mortgage-backed securities behave differently due to their embedded prepayment option, exhibiting negative convexity. When interest rates rise, MBS prices tend to fall more sharply than regular bonds because higher rates extend the life of underlying mortgages. When people refinance less, MBS become more sensitive to rate moves, amplifying the price decline.
Typically, MBS investors such as insurance companies and real estate investment trusts reduce the duration of their portfolios by selling Treasury futures.
Morgan Stanley’s Khanduja said convexity hedging was evident on Tuesday with heavy volume seen in U.S. Treasury futures. There were larger-than-normal block trades in five- to 10-year note futures, with the largest being a transaction on five-year notes of 33,000 contracts, CME Group data showed.
Typical transactions range from about 5,000-8,000 contracts, traders said.
END OF FED’S QUANTITATIVE TIGHTENING
An equally important factor driving this type of hedging is the Federal Reserve’s quantitative tightening, which currently allows $35 billion in MBS to mature each month and puts the proceeds into Treasury bills, rather than buying more MBS.
“This effectively moves the negative convexity of MBS from the Fed’s balance sheet back to the market,” said Harley Bassman, managing partner at Simplify Asset Management. The Fed is winding down this program, and when QT ends those flows will no longer amplify the negative convexity dynamic in the market, analysts said.
Convexity flows in recent years have not been as large as those seen in the run-up to the global financial crisis in 2008. Before the crisis, Fannie Mae and Freddie Mac were the biggest hedgers, actively managing the duration gap between their assets and liabilities. The government-sponsored enterprises have significantly shrunk their mortgage portfolios since the crisis.
At the peak of the Fed’s last quantitative easing program, it held about a quarter of the total MBS market but did not hedge the convexity risk, analysts said.
Amrut Nashikkar, managing director and head of derivatives strategy at Barclays, said this year’s convexity hedging has become a meaningful driver of rates and volatility and is “more destabilizing for rates markets” than in 2023 when Treasury yields were at similar levels.
The market now has more than $2 trillion of MBS carrying coupons of 5% or higher, a share that has grown steadily in recent years, he said. Because these higher‑rate mortgages react more sharply when rates rise, the MBS market has become more sensitive to rate moves.
As older, low-interest-rate loans are paid off and replaced, MBS behave like longer‑dated bonds just as rates are climbing. That means, Nashikkar said, a rise in yields today can trigger bigger, less predictable increases in duration, prompting heavier hedging activity.
(Reporting by Gertrude Chavez-Dreyfuss, editing by Colin Barr and David Gregorio)
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