Surging U.S. Treasury yields have prompted mortgage investors to hedge their loan portfolios by selling government debt, a shift that likely exacerbated the bond selloff this week and led to the biggest rate spike in a year.
Yields climbed after higher-than-expected April inflation reports, fueling expectations that the Fed will hike rates rather than cut them. The benchmark 10-year yield rose 23 basis points in a week and is up over 60 bps since the onset of the U.S.-Israeli conflict with Iran.
Investors holding mortgage-backed securities (MBS) are engaging in "convexity hedging" to reduce risks from slower prepayments as rates rise. This involves selling Treasuries to offset duration extension.
"The velocity of the move in yields has been concerning, with forced selling due to convexity hedging," said Vishal Khanduja, head of broad markets fixed income at Morgan Stanley Investment Management.
The 10-year yield stood at 4.62%, hitting 4.69% on Tuesday, its highest since January 2025. The five-year yield reached 4.35%, a 15-month peak.
The Federal Reserve's quantitative tightening (QT) program, which allows $35 billion in MBS to mature monthly and reinvests proceeds in T-bills, also contributes to the dynamic. "This shifts negative convexity from the Fed's balance sheet back to the market," said Harley Bassman of Simplify Asset Management.
Amrut Nashikkar, managing director at Barclays, noted that convexity hedging this year is more destabilizing than in 2023, as the MBS market now holds over $2 trillion in coupons above 5%, increasing sensitivity.
