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A sharp rise in US Treasury yields has triggered heavy hedging activity among mortgage-backed securities (MBS) investors, adding pressure to the ongoing bond market selloff. Investors managing mortgage-linked portfolios have been selling Treasury futures to reduce risk as higher interest rates slow refinancing activity and extend the duration of mortgage assets. Analysts said the recent volatility has become more disruptive than previous periods of rising yields due to the growing share of high-coupon mortgages in the market. The Federal Reserve’s quantitative tightening programme has also shifted more convexity risk back to private investors, increasing market sensitivity to rate movements.
The recent surge in US Treasury yields has led mortgage investors to increase hedging activity, adding further pressure to the bond market and contributing to the sharpest weekly rise in borrowing costs seen in nearly a year. Advertisement
Treasury yields have moved higher after stronger-than-expected US inflation data reinforced expectations that the US Federal Reserve could keep interest rates elevated for longer and may even consider additional rate hikes instead of cuts. The benchmark 10-year Treasury yield rose by 23 basis points over the past week and has climbed more than 60 basis points since the start of the conflict involving Israel and Iran.
The rise in yields has increased risks for investors holding mortgage-backed securities, commonly known as MBS. These securities are made up of bundled home loans where investors receive payments from homeowners’ monthly mortgage instalments. Since refinancing activity directly affects cash flows from these securities, investors typically hedge against sudden shifts in interest rates.
As rates rise, homeowners become less likely to refinance existing mortgages. This slows prepayments on mortgage loans and increases the duration of MBS portfolios, making them more sensitive to further rate changes. The process of managing this risk, known as convexity hedging, often involves selling US Treasury futures.
Vishal Khanduja, head of the broad markets fixed income team at Morgan Stanley Investment Management, said the speed of the move in yields had become concerning and forced selling linked to convexity hedging had emerged in the market.
The 10-year Treasury yield was last trading around 4.62% after touching 4.69% earlier in the week, its highest level since early 2025. Meanwhile, the five-year Treasury yield climbed to 4.35%, marking a 15-month high. Analysts noted that these maturities are particularly sensitive to convexity-related trading activity.
Unlike traditional bonds that generally display positive convexity, mortgage-backed securities behave differently because borrowers can refinance loans when rates fall. This creates what analysts describe as negative convexity. In a rising rate environment, MBS prices tend to decline more sharply as refinancing slows and the expected life of mortgages extends.
Insurance firms, pension funds and real estate investment trusts that hold large MBS portfolios often respond by reducing portfolio duration through Treasury futures sales. Market participants said trading volumes in Treasury futures rose significantly earlier this week, particularly in the five-year and 10-year segments.
Data from CME Group showed unusually large block trades in Treasury futures contracts, including a single trade involving 33,000 five-year note futures contracts. Traders said normal transaction sizes typically range between 5,000 and 8,000 contracts.
Analysts also pointed to the Federal Reserve’s quantitative tightening programme as another factor amplifying market volatility. Under the programme, the Fed currently allows nearly USD 35 billion worth of mortgage-backed securities to mature each month and reinvests the proceeds into Treasury bills instead of purchasing new MBS.
Harley Bassman, managing partner at Simplify Asset Management, said this effectively shifted negative convexity risk from the Federal Reserve’s balance sheet back into the broader market. Analysts added that once quantitative tightening ends, these flows may stop adding to market instability.
Convexity hedging flows remain smaller than the levels seen before the 2008 global financial crisis, when mortgage giants Fannie Mae and Freddie Mac were among the largest participants actively managing mortgage duration risks. Both institutions have significantly reduced their mortgage holdings since the financial crisis.
At the same time, analysts said the structure of the MBS market has changed over the past few years. Amrut Nashikkar, managing director and head of derivatives strategy at Barclays, noted that convexity hedging has become a more meaningful driver of Treasury market volatility compared to similar yield levels seen in 2023.
According to Barclays estimates, the market now holds more than USD 2 trillion in mortgage-backed securities carrying coupon rates of 5% or higher. Analysts said these higher-rate mortgages react more sharply to rising yields, increasing the likelihood of sudden duration shifts and heavier hedging activity.
As older low-interest mortgages continue to be replaced with higher-rate loans, the MBS market is increasingly behaving like a longer-duration bond market at a time when borrowing costs remain elevated. Analysts warned this could lead to more unpredictable movements in Treasury yields and sustained volatility across fixed income markets.
Source Reuters
5th Jun, 2025
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