Bond Market during deflation

[Kidlicious]

Originally posted by DAVOUT
What do you mean by : Fed and ECB should act ?

Monetary policy should be used to stop disinflation. If it continues investors will lose confidence in the central banks to control the situation. If that happens I think it will be too late.

[Sten Sture]

I wouldn't worry about deflation too much. It takes a pervasive and pronounced deflationary move to be meaningful. Monetary policy should be sufficient to combat it, unless excess capacity isn't removed from the system... etc.


The convexity trade occurs in the bond market when mortgages are being refinanced in large amounts. Everybody who refinances effectively changes a 30yr bond with a 7 year average payment life, to cash. Inorder to offset the radical change in the duration of mortgage assets, long treasuries are usually purchased, driving down interest rates further - and making mortgages more likely to be refinanced. The amount of mortgage bonds in the bond index is 2x the amount of treasuries, so quick mortgage loan repayment can dramatically impact liquidity in treasuries.

Duration is the first derivative of the price-yield equation; convexity is the second derivative.

[Kidlicious]

Originally posted by Sten Sture
The convexity trade occurs in the bond market when mortgages are being refinanced in large amounts. Everybody who refinances effectively changes a 30yr bond with a 7 year average payment life, to cash. Inorder to offset the radical change in the duration of mortgage assets, long treasuries are usually purchased, driving down interest rates further - and making mortgages more likely to be refinanced. The amount of mortgage bonds in the bond index is 2x the amount of treasuries, so quick mortgage loan repayment can dramatically impact liquidity in treasuries.

Does this lead to excess liquidity? That is, do people hold more cash? Can't they find some other investment for more value? Oh, and how does deflation and monetary policy play in to it?

Anyway, I will have to take that comfin course



Thanks Sten

[Saras]

What's comfin?

[Kidlicious]

Originally posted by Saras
What's comfin?

A business finance course?

[Saras]

[TCO]

Originally posted by Sten Sture
I wouldn't worry about deflation too much. It takes a pervasive and pronounced deflationary move to be meaningful. Monetary policy should be sufficient to combat it, unless excess capacity isn't removed from the system... etc.


The convexity trade occurs in the bond market when mortgages are being refinanced in large amounts. Everybody who refinances effectively changes a 30yr bond with a 7 year average payment life, to cash. Inorder to offset the radical change in the duration of mortgage assets, long treasuries are usually purchased, driving down interest rates further - and making mortgages more likely to be refinanced. The amount of mortgage bonds in the bond index is 2x the amount of treasuries, so quick mortgage loan repayment can dramatically impact liquidity in treasuries.

Duration is the first derivative of the price-yield equation; convexity is the second derivative.

Could you explain that slower? I assume that the nature of the mortgage (allows refinancing) has an implicit risk for the lender, for which he should demand a slightly higher real rate. When a wave of refinancing occurs, it is just the banks taking a haircut.

[TCO]

Originally posted by DAVOUT
Deflation can be analysed as an addition to the interest rate.

ok.

Therefore, when deflation appears, without an equivalent decrease of the interest rate, the price of bonds should decrease.

The reverse, no? Since the real yeild has increased.

If interest rates decrease more than the deflation, the price of bonds may increase.

opposite, no?

[TCO]

Hey guys, I have Dunkan-Kid on ignore. Would I gain anything by looking at his posts?

[Saras]

Mmm... No, not really

[Kidlicious]

Originally posted by GP
Hey guys, I have Dunkan-Kid on ignore. Would I gain anything by looking at his posts?

Well, for example you might know that DAVOUT was talking about the real interest rate instead of the nominal rate. What are you doing in here anyway? I started this thread. How are you going to know what we're talking about if you don't read my posts.

[Sten Sture]

Ever heard of that stuff Shares? (I shorten it to corpfin...)

Does this lead to excess liquidity? That is, do people hold more cash? Not intentionally, but defacto because of the transactions occuring in the refi side of things, more cash is held temporarily as the old mbs (mortgage backed securities) are paid back and the new ones are issued. There is a peculiar time delay in the american mbs market of 15 or 25 days (FNMA and FHLMC are on different schedules) between the accrual period and the interest and principle payment dates. Somewhat similar to stocks going ex-dividend. If I own a 30yr FNMA 6% pool in April, then I know that refi's are going to be pretty high, but my payment doesn't come in until May 25th, so that cash is in transit between various intermediaries from the 1st or 5th or whenever the borrower closes on their new loan.

The number of securitized loans in the American mbs market is monsterous. Very few lending institutions retain their mortgage production, favoring the liquidity, and diversity of buying generic pools of loans from all around the country. What they do retain is the servicing of the loans that they make, which generally keeps about 50 basis points (0.50%) of the interest.

In a deflationary environment, you want as much duration (maturity adjusted for interest cash flow) as you can get in your portfolio, that is one reason we have seen bonds rally so much over the past couple of years. DAVOUT's first post was a little confusing in that regard. As nominal interest rates decline, bond prices go up, and go up a lot more as they get really low, because of their positive convexity. They get less cash flow the lower yields go, and their duration extends.

Deflation makes bonds extremely valuable, unless you are talking about large declines. 2% is not significant. Your fixed future cash flows will buy more goods in the future, while a stock represents declining cash flows since they are selling their products for less money.

[DAVOUT]

Originally posted by GP


ok.



The reverse, no? Since the real yeild has increased.



opposite, no?

When the yield increases, a bond valued 100 before the increase will be valued less because investors are no longer willing to pay 100 to get only the previous rate.

Same thing, but reverse when the yield decreases.

[Saras]

This aint corpfin... its fixed income math, aint it? I once tried to comprehen a paper on MBS/ABS valuation and almost fainted

[Sten Sture]

Originally posted by GP


Could you explain that slower? I assume that the nature of the mortgage (allows refinancing) has an implicit risk for the lender, for which he should demand a slightly higher real rate. When a wave of refinancing occurs, it is just the banks taking a haircut.

sorry. The banks do take a haircut, they own an asset - the servicing portfolio - that is in effect an interest only strip of the mortgage. Therefore when the bonds get refi-ed, if the servicing bank doesn't make the loans, their asset goes to ZERO. Ouch! The interest spread between funding and loan rates is about 80% this factor, not credit risk. Mortgages used to trade much tighter to treasuries before this instant no-cost refi business narrowed the refi trigger rate.

got the folks in town today; I'll be out for a while... cheers.