By Julia-Ambra Verlaine 

A major driver of the roaring 2020 bond-market rally is the insatiable demand of major U.S. banks whose hedging needs have risen with each fresh decline in rates.

Thanks to this year's bond rally, banks need to buy around $1.2 trillion of 10-year Treasury bonds to offset risks on mortgages and bank deposits, according to J.P. Morgan research estimates. Commercial banks own around $3 trillion of U.S. Treasury and government-agency securities, Federal Reserve data show.

The 10-year yield, which helps set borrowing costs on everything from home loans to business loans, has been pushed lower by worries about the coronavirus's potential impact on the economy, which resulted this past week in the Fed's first emergency rate cut since the financial crisis.

The yield traded at 0.714% Friday, down from 1.90% at the beginning of the year. The plunge both reflects and intensifies commercial banks' efforts to manage balance-sheet risks including sensitivity to interest-rate swings. This practice, known in industry parlance as convexity hedging, has been a significant factor in the bond market for years but has become even more acute in the postcrisis era as a result of tighter rules adopted after the 2008 crisis.

"Convexity tends to exacerbate market moves -- if rates are going lower, convexity will make the move sharper," said Gennady Goldberg, U.S. rates strategist at TD Bank.

Here is how it works. When interest rates fall, many homeowners who took out fixed-rate mortgages refinance to lock in lower monthly payments. The owners of the relevant mortgages and mortgage-backed securities -- including the banks -- lose out on higher payment streams. As a result of this, the prices of mortgage bonds tend to rise less in any given bond rally than Treasury securities or some other bonds, making them "negatively convex."

Banks hedge their holdings of mortgages and other assets to limit these sorts of losses, but doing so often entails buying new assets including Treasurys. Banks also use interest-rate derivatives to offset potential losses from changes in rates -- usually swaps, in which the bank typically exchanges the right to a fixed payment for a floating payment under specified terms.

The sharp decline in rates is making banks even bigger buyers of Treasurys, as the probability of mortgage refinancing increases and they seek to bridge expected income shortfalls generated when higher-paying fixed-income securities "prepay," as traders say when refinancings enable a bond to be paid off early. The same dynamic plays out to some extent with deposits, which are liabilities that the banks seek to match with assets, a match that often comes under pressure when the rate environment changes significantly.

The three largest U.S. banks by assets, JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo, have steadily grown since the financial crisis, expanding their mortgage books and raking in more consumer deposits via money-market, checking and savings accounts. That means bigger hedges to manage risks.

JPMorgan Chase held an average of $215 billion worth of residential mortgages on the books at the end of 2019, compared with $143 billion a decade earlier. Wells Fargo deposits have risen to $890 billion last year from $787 billion in 2016. Interest-bearing deposits at Bank of America jumped nearly 20% over the past two years to $900 billion in 2019.

In part as a result of larger mortgage and deposit balances, both of which can require hedging, banks have grown more sensitive to rate changes. JPMorgan research analysts estimate the expected increase in net interest income for banks for a 1 percentage-point rise in rates is $8 billion, up from $6 billion last year. Those figures generally work in reverse when rates fall.

This sensitivity can be painful when banks misjudge the economic outlook or market sentiment. In 2018 many large banks were wrong-footed by the year-end market meltdown that ended in the Fed's decision to begin cutting rates following several years of increases.

The scale of these moves and the ripples from banks' efforts to hedge them underscore the tightrope the Fed is trying to walk as it seeks to keep the economy on track in the face of rising coronavirus fears.

"If the Fed overreacts and cuts too much, it creates other dynamics that hurt insurance companies, pension funds and the banking system," said Rick Rieder, chief investment officer of Global Fixed Income at BlackRock Inc.

Compounding the problem, banks are hamstrung by postcrisis capital rules that have made assets like corporate bonds expensive to hold, making it difficult for them to buy assets with long duration they can carry on the balance sheet.

Accordingly they now are buying products long preferred by insurance companies, including collateralized mortgage obligations -- financially engineered mortgage bonds sold in grades that can make higher-rated ones less vulnerable to prepayment risk -- in the hunt for longer-lived assets that they can hold.

"This rally has exacerbated an already significant issue," said JPMorgan's head of interest-rate derivatives research, Joshua Younger.

Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com

 

(END) Dow Jones Newswires

March 06, 2020 08:57 ET (13:57 GMT)

Copyright (c) 2020 Dow Jones & Company, Inc.
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