Morning Notes — Bond Yields Explained

Economic conditions have yet to match downbeat market expectations. The mismatch only adds to the uncertainty, which has fueled large scale ‘risk off’ positioning out of equities and into bonds. Fed fund futures are pricing in another 50bps of rate cuts this year. Bond yields have mostly followed Fed fund futures with understandable curve steepening. But absolute yields on 10 and 30-year Treasuries are still falling. Why? Who’s buying bonds with 10-year yields below 1%? The short answer is banks and insurance companies. Using banks as an example, mortgages have something called ‘negative convexity.’ This means the duration of the mortgage gets shorter as rates go down. Homeowners pay off their existing higher interest rate mortgage when rates go down (refinance). If you’re a bank who wants to maintain a constant duration position (regulated), you need to add back positions, which means you’re buying bonds in a market of rising bond prices/falling yields. What makes matters worse, is that bank deposits have ‘positive convexity’…meaning deposits tend to get stickier when rates fall and less-sticky when rates rise and investors can find substitutes (money funds) with higher yields. The mortgage/bonds held by banks is an asset, while customer deposits are a liability. So, the bank’s assets are getting shorter and their liabilities are getting longer. Banks are then forced to buy duration in what’s called ‘convexity hedging.’ The bank isn’t buying bonds as an investment, they’re buying bonds as a risk management exercise that turns into a virtuous cycle…until you approach the ‘zero bound.’