US bond investors weigh 'convexity' risk in recent Treasury yield decline

Gertrude Chavez-Dreyfuss

Tue, Mar 25, 2025, 3:04 AM 4 min read

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) -The recent drop in U.S. yields has raised speculation that a wave of buying of Treasury securities and derivative products called interest rate swaps by mortgage portfolio managers and insurance companies was partly responsible for their decline.

These purchases are for "convexity" buying that helps offset the effects of mortgage refinancing to take advantage of lower interest rates. They could amplify the decline in Treasury yields that has taken place in recent weeks due to concerns about economic growth.

Convexity is a term describing how small changes in interest rates can have a disproportionate impact on an asset manager's portfolio or an insurer's balance sheet.

Convexity buying looks to have started early this month, as yields slid to the lowest since late October, from 15-month highs in February, analysts said.

The benchmark U.S. 10-year yield, which influences the cost of borrowings on homes, cars, and businesses, has not moved much since bottoming around 4.10% on March 4, after a 56-basis point decline since February 6. But the yield fell 18 bps from March 13 to 4.17% on March 20.

"There's always convexity hedging going on," said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities in New York, citing the amount of uncertainty in markets from mid-January to the end of February and early March.

"It varies in intensity. But it's a large enough move for folks to position their portfolios."

When rates fall, mortgage players including originators, servicers, and investors in mortgage-backed securities (MBS) - insurance companies and real estate investment trusts (REITs) -typically shift hedges on mortgage holdings to balance their portfolios.

Mortgages and MBS allow borrowers to refinance or prepay their loans when rates fall. These prepayments shorten the average life of the mortgage bond, reducing its yield, with the price increasing less than expected when rates fall. This is called "negative convexity" and leaves investors with lower portfolio duration than their benchmark.

While 64% of outstanding mortgages are locked into interest rates below 4%, about 16% have rates above 6%, which could be refinanced quickly when rates fall, Goldman Sachs, in a research note, said.

To keep their portfolio duration in line with their benchmarks, MBS investors will buy either Treasuries, or Treasury futures. They can also buy an interest rate swap, wherein they would receive a fixed rate while paying a floating one, a trade that protects against falling rates.