Uncertainties moving into extra time

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Although the sovereign-debt crisis sent the price of the 2040 Hellenic Republic bond below the 50% mark, or under its level before the eurozone’s EUR750bn bailout package, it has barely impinged on US or Japanese government debt securities. At the time of writing, 10-year Japanese government bonds are yielding 1.10%, while benchmark 10-year US Treasuries are at 2.98%, their lowest level in the past twelve months. In terms of fundamentals, the steep drop in bond yields highlights the mounting risks of deflation around the developed world. But there is also another element to falling US Treasury yields, and a peculiarly technical one.

Mortgage-backed securities (MBSs) account for 37% of the total bond market in the US.The behaviour of the MBS segment is critically influenced by the option available to mortgage borrowers, at any time, to refinance a 30-year loan at the going rate of interest, if market rates become more attractive. Recently, standard mortgage rates have dipped to new lows. Because of the increasing likelihood that US homeowners will move in droves to refinance their mortgages, the implied duration in MBS prepayment models has shortened from five years to just one year in the space of a mere couple of months.