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The rush to purchase Treasurys continues unabated and keeps bond yields at historically low levels.
Trade war concerns have been the main catalyst for this decline, which occurs when bond prices rise as demand rises. Investors are avoiding risky assets that could cause huge drawbacks in the event of a recession and turn to more reliable investments, such as the US public debt.
But behind the scenes, a sizeable segment of the bond market is contributing to this fall as its investors cover their own set of risks.
These are none other than mortgage-backed securities, sets of homeowners' debts that played a tragic role in the exacerbation of the 2008 financial crisis. The problem, at the time, was that these securities There were too many mortgages that banks had approved for at-risk borrowers, who would end up having trouble making their monthly payments.
Today, the issuance of mortgage-backed securities is more technical than fundamental. But that does not mean that their training effects are not felt beyond their territory.
"They have problems right now," said Colleen Denzler, an investor at Smith Capital, who was previously global fixed income manager at Janus Henderson. The Smith Capital Total Return Bond Fund, which is managed jointly with Alps Advisors, has gained 11% over the past year and outperformed 94% of its peers over this period, according to data from Bloomberg. The company has approximately $ 350 million in assets under management.
The steep drop in bond yields is causing problems with mortgage-backed securities.
Whenever interest rates fall in the same way as recently, current homeowners can take advantage by refinancing their mortgage. This essentially involves exchanging an existing mortgage against a new one with a lower rate and cheaper monthly payments.
The problem with this scenario for Wall Street is that as homeowners give up their old loans, investors in such mortgage-backed securities recover their capital sooner than expected.
In doing so, they lose the returns they would have achieved if the homeowners kept their mortgages longer and if the overall duration of their portfolio was shortened.
The risk of this double loss is called negative convexity. At the moment, it is so important that investors hedge against this situation by buying Treasury bills to offset the withdrawal of long-term debt from their portfolio.
Purchasing treasury bills is the usual answer for mortgage-backed securities investors who want to protect themselves – except that bond yields fall further as demand and purchases rise. And so, what should be uneventful coverage has created a vicious feedback loop: historically low returns are increasing the need for hedging, which leads to more bond purchases that further erode yields.
"What's happening right now is hurting because when you go for these extreme moves, they're just not good for the title structure," Denzler said.
The vicious circle could persist for a while
The meteoric recovery of bonds, which triggered recessionary signals and was described as a bubble by other experts, could continue unabated. Even if there was to be a quick fix to the trade war, Denzler sees the US-China conflict as a longer term problem.
"Bubbles burst when the situation changes, be it because of a crisis or a change in what caused them," she said. "It could be a moment, and that's how we are positioned."
She added that she was underweight in mortgage-backed securities. She also advised investors to be wary of index products that track the broader fixed income market.
"In stock, it's great," said Denzler about buying index funds. "In fixed mode, you face all the biggest risks – and people have no idea."
For example, she said, the most heavily indebted companies are also the most exposed to the credit risk of the Bloomberg-Barclays benchmark. This means that they could be the most affected by an economic downturn, depending on the strength of their balance sheets.
The SPDR Bloomberg Barclays US Aggregate Bond Exchange Fund tracks the benchmark, and mortgage-backed securities represent approximately 27% of its holdings – the largest share next to Treasurys.
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