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Ed Rooney for Live With a Net © Publications
May 11, 2005
Mortgage bond investors were relieved as payroll data for April banished fears of a refinancing wave.
The big worry was a weaker-than-expected number would send the 10-year Treasury yield back down
toward 4% or possibly lower, which would have led to fears of a pickup in mortgage refinancings.
But worry turned to euphoria - and mortgage bond out-performance -when the higher-than-expected employment number was released. In addition to the 274,000 increase in jobs reported for April. Growth for the two prior months, March and February, was revised upward to 146,000 from 110,000 and 300,000 from 243,000 respectively.
The 10-year Treasury yield rose to near 4.24% and investors showed much more enthusiasm than they have recently. There is confidence that the 10-year Treasury yield won't go below 4%.
While mortgage bonds generally under-perform if there are large changes in the yields of 10-year Treasury's, with rates going sharply lower it is typically worse than if rates go sharply higher.
There is an increased incentive to refinance mortgages when rates drop sharply. That means a bondholder whose bonds are backed by mortgages might see cash flow from bonds evaporate. When portfolio managers have funds returned early from refinancings they will generally need to reinvest the money at lower rates.
When refinancings do pick up it becomes more expensive to hedge mortgage bond positions and general under-performance follows. When rates are falling sharply, investors will sell mortgage bonds and buy Treasury's in an attempt to buy bonds with prices less sensitive to changes in rates. Switching into Treasury's can sometimes worsen the situation by making Treasury's rally, so yields drop even further on increased demand. April's data seem to have stopped this for now.
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