Monday, December 22, 2008
Why are yields so low in the Treasury market? Focusing on the longer dated maturities (10 - 30 years):
- Continued flight to quality. Treasuries are backed by the full faith and credit of the Federal government, i.e. its ability to tax citizens.
- Slowing economy. Whether we wind up with disinflation or deflation, the future purchasing power of the earned interest and principal SEEMS to be safe. You can think of a risk free bond yield as a combination of an inflation component and a growth rate of the economy component. Neither one seems to be poised to move higher in the near term. The market is becoming more confident in that assumption, so they are buying longer dated bonds.
- Mortgage market hedging. This is the big one. A mortgage payment is composed of both principal and interest. The string of cashflows is impacted by current mortgage rates because of the motivation to refinance. As rates fall, the value of outstanding mortgages increase slightly. But if the rates fall too much, refinancing activity will cause the prepayment of outstanding mortgages and erode the value of a bank's portfolio. To hedge this risk, mortgage holders need to acquire securities that will continue to add value if rates fall to compensate them for the underperformance of the mortgages. Please drop me a line if you would like to discuss this topic further. It has the potential to really damage balance sheets in this environment.
Posted by MK at 8:49 AM