After last month’s bond market turmoil, few can be unaware of the havoc that US mortgage borrowers can cause with their habit of remortgaging every time the interest rate slips. It changes the duration of mortgage portfolios, which in turn leads investors (whether Freddie Mac and Fannie Mae or the holders of their bonds) into complicated hedging strategies.

Put simply, when the yield goes down and mortgages are repaid, duration shortens and investors hedge by buying long-dated treasuries. This pushes yields down further and flattens the yield curve.

When yields rise, however, the causal chain goes into reverse: mortgagees do not repay, portfolio duration lengthens and investors sell long-dated bonds, pushing yields up even further. The recent hiatus in the bond market was due to this process kicking off.

For governments that are keen on fixed rate mortgages – the UK’s Chancellor Gordon Brown is one fan – it’s worth remembering that there is a cost in terms of bond market volatility.

Fixed-rate mortgages are attractive in that borrowers can plan their finances better and are less likely to get into difficulties when interest rates spike upwards.

There are political gains in this – homeowners are happier – and macroeconomic gains – GDP growth is not upset by housing recessions.

But putting mortgagees in the driving seat of the bond market is less attractive. Corporate and sovereign issuance plans could be disrupted because 23 Acacia Avenue decided to remortgage or not.


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