BY ALEC HOLLIS
Post-election stress may be affecting more than just the public; since the election, the U.S. Treasury bond market has sold off sharply, and the 10-year treasury interest rate has increased with it. As a result of increasing interest rates and a steeper yield curve, one may notice mortgage loans and other mortgage-related assets have had much slower projected prepayment speeds, and therefore increasing modeled durations. Such changes in the marketplace could have drastic impacts on modeled interest-rate risk results and, thus, may warrant a discussion of ALM metrics.
Over the last couple of years, the U.S. Treasury bond market has experienced a rather interesting dynamic. The curve has flattened to multi-year lows not seen since it began steepening again from the financial crisis in 2007. Examining Figure 1, the curve flattened 190 basis points (bps) from its peak of 266 bps at the end of 2013 to 76 bps in Q2 of 2016. This has had a major impact on mortgage pricing, as pricing reached all-time highs and effective durations fell to all-time lows. However, the recent reversal of the flattening trend has mortgage durations back on the rise again.
The recent uptick in the level and slope of the term structure of interest rates has the general impact of extending durations on negatively convex assets, which will impact the interest-rate risk of a balance sheet. The extent of the impact will depend on the balance sheet’s convexity risk, which can be quantified by examining the convexity of equity or the convexity gap. Most credit unions (and banks for that matter) tend to have negative convexity gaps because they have call options on the balance sheet. For mortgage assets, the prepayment option is effectively a call option; when interest rates fall, the market value of the borrower’s debt rises, and therefore they prepay (i.e., “call”) the note and refinance into a lower rate. In effect, this means a shift up and/or steepening generally leads to less refinance-ability of mortgage loans and, thus, an extension in the duration. While not every borrower is paying close attention to interest rates, this general relationship is very strong and observable in the marketplace.