| Key Points: – Falling Treasury yields have triggered increased convexity hedging by mortgage investors and insurers. – The spread between 10-year swap rates and Treasury yields has tightened, indicating rising demand for fixed-rate protection. – Convexity-driven market activity may amplify rate movements and impact broader financial markets. |
The recent decline in U.S. Treasury yields has sparked renewed interest in “convexity” hedging, a strategy employed by mortgage portfolio managers, insurance companies, and institutional investors to adjust their risk exposure. As yields have dropped to their lowest levels since October, analysts suggest that significant convexity-related buying has played a role in accelerating the decline.
The benchmark U.S. 10-year Treasury yield, which serves as a key barometer for borrowing costs across the economy, bottomed at 4.10% on March 4 after a notable 56-basis-point drop since early February. While the yield has stabilized in recent weeks, it fell again by 18 basis points from March 13 to 4.17% on March 20, raising speculation about continued hedging activity.
Convexity refers to how changes in interest rates disproportionately affect bond prices and portfolio durations. Mortgage-backed securities (MBS) are particularly sensitive to convexity risks because mortgage holders tend to refinance their loans when rates fall, leading to an increase in early repayments. This shortens the expected duration of mortgage bonds, reducing their yield and leaving investors with less exposure to fixed income than they initially planned.
To counterbalance this effect, institutional investors—such as insurance firms, pension funds, and mortgage servicers—purchase Treasuries, Treasury futures, or interest rate swaps to maintain their portfolio durations. This rush to hedge can create a feedback loop, pushing Treasury yields lower and further increasing the need for convexity hedging.
Recent data indicates that convexity hedging has intensified, influencing key financial indicators:
- Tightening Swap Spreads: The spread between 10-year interest rate swaps and 10-year Treasury yields has become more negative, with swap rates declining due to increased demand for fixed-rate protection. As of March 25, U.S. 10-year swap spreads had narrowed to -44 basis points from -38.3 basis points on February 14.
- Increased Options Market Activity: Short-term implied volatility on longer-dated swaps has risen sharply, with three-month implied volatility on 10-year swap rates hitting a four-month high of 27.71 basis points on March 10 before settling at 25 basis points.
- Hedging Demand from Mortgage Investors: While 64% of outstanding U.S. mortgages are locked in at rates below 4%, about 16% have rates above 6% and could be refinanced quickly if interest rates continue to fall, increasing the need for further hedging.
Convexity hedging can create self-reinforcing cycles that amplify rate moves. When Treasury yields fall sharply, increased buying by mortgage investors and insurers can push them even lower. Conversely, if rates rise unexpectedly, convexity hedging could shift in the opposite direction, triggering selling pressure that accelerates rate increases.
For insurance companies, falling yields present a profitability challenge, as lower rates reduce returns on their fixed-income investments. This can impact both policyholder returns and shareholder earnings.
Moreover, heightened market volatility—particularly around the Trump administration’s evolving trade and tariff policies—has contributed to elevated uncertainty in interest rate markets. Investors are closely watching Federal Reserve policy signals, as unexpected rate cuts or macroeconomic shifts could further accelerate convexity-driven market moves.
While active convexity hedging has declined from its peak in the early 2000s—when 27% of mortgage investors actively adjusted their portfolios compared to just 6% today—it still plays a meaningful role in driving short-term Treasury yield fluctuations. With continued uncertainty over economic growth and inflation trends, convexity hedging is likely to remain a key factor influencing fixed-income markets in the months ahead.