The market for U.S. mortgage-backed securities is re-emerging as a significant source of instability for the Treasury market. As hundreds of billions of dollars in high-rate mortgages are packaged into new securities, convexity hedging activity has become lively again after years of dormancy, leaving a noticeable mark on last month's bond selloff. Analysts warn this mechanism is severely underestimated by the market and could trigger a new round of amplification if Treasury yields decisively break through key levels.
During the heavy selling in Treasuries last month, Vishal Khanduja, a portfolio manager at Morgan Stanley Investment Management, noted an unusual signal: a flood of large Treasury futures sell orders appeared precisely when mortgage-backed securities were under severe pressure, coinciding with a surge in the longest-dated Treasury yields to near 19-year highs. He concluded this indicated other investors were engaging in convexity hedging to protect their MBS holdings—by buying derivative positions that profit when Treasury prices fall.
The renewed activity of this strategy is adding a new source of volatility to the already turbulent $31 trillion Treasury market. Bloomberg strategist Alyce Andres points out that the benchmark 10-year Treasury yield is testing a critical level. A decisive break above it could trigger a concentrated influx of convexity hedging flows, pushing yields even higher. Barclays strategist Amrut Nashikkar warns, "Higher yields create a lot of negative feedback loops, raising fiscal financing costs and worsening an already concerning fiscal outlook."
The Mechanics of Convexity Hedging: A Pro-Cyclical Amplifier
Convexity hedging is a core tool for MBS investors to manage interest rate risk, and its operational logic inherently creates a pro-cyclical effect with market movements.
Specifically, when borrowing costs rise, homeowners' willingness to prepay or refinance declines, lengthening the actual duration of MBS. This means that for each unit increase in rates, the security's price falls more sharply. To hedge this risk, investors typically establish derivative positions that profit when Treasury prices fall, creating additional selling pressure during market downturns. Conversely, when rates fall and refinancing expectations heat up, this mechanism can amplify bond market rallies.
Goldman Sachs estimates that the recent selloff has significantly expanded the interest rate exposure of active MBS hedgers, with a scale roughly equivalent to the duration risk generated by buying an additional $40 billion in 10-year Treasuries.
The Catalyst: A $2 Trillion Pool of High-Rate MBS
The fundamental reason convexity hedging is becoming a force to watch again lies in a profound shift in the structure of the MBS market.
Following the Federal Reserve's aggressive rate hikes in 2022, a massive amount of low-rate mortgages became deeply "out of the money," with MBS prices falling far below their face value, causing convexity risk to nearly vanish—there was little need to hedge further declines, and homeowners had little incentive to refinance. However, in the years since, hundreds of billions of dollars in new, high-rate mortgages have been packaged into securities. Barclays estimates that the size of MBS with coupon rates of 5% or higher now exceeds $2 trillion, roughly four times the level from three years ago.
Harley Bassman, creator of a bond market volatility index, noted in a recent report titled "Awakening the MBS Convexity Monster" that about one-third of the outstanding MBS pool now trades near its face value—the zone where convexity sensitivity is highest. This means investors need to rebalance their hedge positions more frequently, a process that itself amplifies market volatility. "This is large enough to move the market," he stated.
Private Investors Step In as the Fed Exits
The withdrawal of the Federal Reserve is another key factor behind the re-emergence of this risk.
During the pandemic, the Fed accumulated over $2.7 trillion in MBS to inject liquidity. After inflation surged, the Fed stopped buying and began significantly reducing its holdings. Private investors, such as hedge funds, subsequently filled the gap—but unlike the Fed, private investors typically hedge their interest rate exposure.
Bassman remarked, "For the past ten to fifteen years, this mechanism hasn't mattered because the mortgage market basically moved in sync with the Treasury market. Now, it's starting to matter again." He expects Treasury market volatility to increase as this structural shift deepens.
Barclays' Nashikkar also believes the MBS market's potential to disrupt rates is currently severely underestimated. "The MBS market today is starkly different from what it was in 2023," he said. "The extent to which it can now disrupt the rates market, I don't think is fully appreciated."
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