* Spike in Treasury yields halts Asian issuance
* Losses curb appetite of bond buyers
* Analysts say mortgage hedging could accelerate move
By Christopher Langner and Neha D‘Silva
May 30 (IFR) - Asian bond investors and bankers have recently taken a keen interest in the US secondary market for mortgages.
The shift in focus has to do with the recent spike in US Treasury yields, which has brought Asian dollar bond issuance to a standstill, despite a record US$86.7bn having been printed so far this year.
The return on 10-year US Treasuries rose 44bp in May, increasing the cost of debt for issuers and inflicting losses on investors as investment-grade bond cash prices, which move inversely to yields, dropped in Asia.
“Until Treasury markets stabilize, we would expect supply to stay limited,” said Krishna Hegde, head of Asia credit research at Barclays.
The fear now is that yields could keep rising and further undermine the Asian dollar bond market’s growth. Besides the shift in economic and inflation expectations that has fuelled the recent move in Treasury prices, rates strategists are saying that US mortgage investors hedging their positions could push benchmark bond prices even lower.
The issue stems from a technicality in the US mortgage market that could have wide-ranging effects for all corporate bonds denominated in dollars - including those in Asia.
Mortgage rates in the US are benchmarked against 10-year US Treasury paper - so mortgage rates rise in tandem with Treasury yields. Indeed, the average interest on the 30-year fixed-rate mortgage in the US has risen to 3.9%, as of May 30, from 3.59% on May 1.
As the fixed mortgage rate on offer becomes higher than the one that debtors hold, there is little incentive for Americans to refinance. For investors who buy mortgages in the secondary market, this translates into a longer holding period.
Here lies the risk to the bond markets. Mortgage investors tend to hedge the higher duration in their portfolios by shorting the underlying benchmark, in this case the 10-year US Treasury, something known in the investment world as delta or convexity hedging.
Given the size of the secondary mortgage market - there are more than US$ 13.1trn in mortgages outstanding, according to the US Federal Reserve - if only a fraction of players decide to hedge their portfolios it could easily cause Treasury yields to climb much higher.
Older market hands remember the summer of 2003 as the classic example of the effect mortgage convexity hedging can have on Treasury rates. Between June 16 and September 9 that year, yields on 10-year US Treasuries rose 150bp, partly because of mortgage holders protecting themselves against rising rates.
It is unclear at what point the mortgage investors would start hedging their holdings this time around. However, some strategists believe a yield of 2.25% on the 10-year Treasury could trigger the move. “This discussion is happening a lot, nobody is too sure where the hedge level is, but we know there is a possibility (Treasury yields) could spiral higher,” said a head of credit strategy in Hong Kong.
If that were to happen, it could cause a rout in the Asian bond market. The recent rise has already hurt many investors. Holders of Temasek’s 2042 bonds, for instance, would have shown a loss of 7% in May as the bond’s price dropped to 86.25 as it kept up with Treasury prices.
“The Treasury sell-off is obviously affecting prices in high grade and we have seen a reduced appetite for duration,” Hegde said.
In other words, investment-grade bonds are a tougher sell these days. It is no surprise that Thai oil giant PTTEP’s subordinated perpetual bond, marketed in the third week of May, is still yet to print.
One banker said that there was about US$10bn of investment-grade bonds to be issued before the end of June. “Now everything has been taken back to the drawing board,” he said, suggesting that issuers and bankers have to review their yield expectations.
And funds have started raising cash as they become afraid of potential redemptions from investors seeing losses on the bonds in their portfolios. Even high-yield, which is less affected by Treasury yields, is beginning to suffer.
“In high yield, the risk-off sentiment has dragged down prices; in global markets, even the high-yield CDX index in the US, which is purely a spread product with limited rate sensitivity, is down more than two percentage points from its highs last week,” Hegde said.
All this has created an unusual hope among bankers and investors. “We are in that situation that bad news would be good news,” said one syndicate banker. “If GDP and employment numbers in the US come weaker than expected, that would reverse the yield rise in Treasuries,” he said. “Then, who knows, we might even get to US$100bn (in Asia) before the end of this half.” (Reporting By Christopher Langner and Neha D‘Silva; editing by Nachum Kaplan)