- Mortgage convexity hedging — where MBS holders sell Treasuries in selloffs and buy in rallies — is re-emerging as a market force after years of dormancy, adding a new source of amplified volatility to the $31 trillion Treasury market.
- Goldman Sachs estimates May’s bond selloff increased the interest-rate exposure of active MBS hedgers by the equivalent of buying $40 billion of 10-year Treasuries — a significant, largely invisible flow.
- Over $2 trillion of mortgage securities now carry 5%-plus coupons (4x the level of three years ago), and roughly a third of all outstanding MBS now trade near par — the zone of peak convexity sensitivity.
- The Fed’s near-total exit from the MBS market has left hedge funds as dominant holders; unlike the central bank, they hedge their exposure, reintroducing a feedback loop the market hasn’t had to contend with since before the pandemic.
What Happened?
As Treasury yields surged toward 19-year highs during last month’s bond selloff, Morgan Stanley Investment Management’s Vishal Khanduja noticed something: large waves of futures sales hitting the market precisely when mortgage-backed securities were taking their hardest hits. The pattern was unmistakable — convexity hedging was back. Investors holding MBS are forced to sell Treasuries when rates rise (because rising rates reduce refinancing, effectively extending the duration of their securities) and buy Treasuries when rates fall. Barclays analyst Amrut Nashikkar warns this “has been under-appreciated” — the MBS universe today looks radically different from 2023: over $2 trillion in securities carry 5%-plus coupons, and about a third of all outstanding mortgage bonds trade near par, where sensitivity to rate changes is greatest.
Why It Matters?
Convexity hedging was a significant amplifier of bond market volatility in the late 1990s and early 2000s, earning the nickname the “Beast.” It largely disappeared after 2022 because the pandemic-era low-rate mortgages had fallen so far in price that further hedging was unnecessary. But hundreds of billions in higher-rate mortgages originated since then have rebuilt the pipeline. Goldman Sachs estimates the May selloff generated hedging flows equivalent to $40 billion in 10-year Treasury purchases — a large, non-fundamental flow that can deepen selloffs and extend rallies. Harley Bassman, creator of the MOVE bond volatility index, recently titled a client note “Awakening the MBS Convexity Beast” and warned that about a third of outstanding MBS now sit at par, where this dynamic is most powerful: “This is becoming big enough to impact the market.”
What’s Next?
The 10-year Treasury yield is testing a technical level that, if decisively breached, could unleash a fresh round of convexity hedging flows, according to Bloomberg macro strategists. The Fed’s ongoing balance sheet reduction means it won’t act as a shock absorber — private hedge funds, which actively hedge their duration exposure, are now the marginal holders. Combined with existing pressures from the Iran war oil shock, AI-related debt issuance, and new Fed leadership, the return of convexity hedging adds another layer of complexity to an already stressed fixed-income market. “You will see more volatility,” said Bassman. “The last 10, 15 years, it has not been that important. Now, it’s coming back.”
Source: Bloomberg
