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Bond investors face 'untold damage' when interest rates rise; While traditional bonds look precariously positioned, rising interest rates are unlikely to have a negative impact on ...
Topic Started: 10 Oct 2013, 09:27 AM (630 Views)
herbie
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http://www.telegraph.co.uk/finance/personalfinance/investing/bonds/10366379/Bond-investors-face-untold-damage-when-interest-rates-rise.html
A Professional Demographer to an amateur demographer: "negative natural increase will never outweigh the positive net migration"
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Elastic
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Quote:
 
If local interest rates were to rise by just by 1 percentage point, "long-duration UK treasuries" – British government gilts more than a few years from maturity – would lose as much as 16pc of their value, he said.


This is the reason that the Fed is buying all the treasury bonds and the MBS from the banks. They face huge losses if IRs ever rise.
It occurred to me that MBSs are no different to bonds as far as banks are concerned. Because most of the mortgage loans are fixed rate for 25-30 years, they are essentially like a bond as far as an investor is concerned. They have created an asset with a long term yield. If IRs go up then the new owners of the loan money may deposit that money in the bank and want a decent return thus inflicting a loss on the bank.
Only a rat can win a rat race.

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miw
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Elastic
10 Oct 2013, 10:27 AM
This is the reason that the Fed is buying all the treasury bonds and the MBS from the banks. They face huge losses if IRs ever rise.
It occurred to me that MBSs are no different to bonds as far as banks are concerned. Because most of the mortgage loans are fixed rate for 25-30 years, they are essentially like a bond as far as an investor is concerned. They have created an asset with a long term yield. If IRs go up then the new owners of the loan money may deposit that money in the bank and want a decent return thus inflicting a loss on the bank.
The Fed will probably be OK, because they can almost certainly let the bonds and MBS just roll off. Book value gyrations don't make them suffer margin calls. (But there are some that say they will be forced to sell the securities at a loss if inflation spikes).

Private holders of MBS like the mREITS have to pay a huge amount of attention to this. Typically they leverage up their capital 5-8 times and use constantly rolling over repos with terms from 3 months to 2 years to buy MBS which are, as you say, like bonds with a duration somewhere around the 6-7 year mark. If interest rates spike fast, they get margin calls and since they have a target leverage ratio, this means they have to sell MBS to cover, so these guys lost as much as 25% of their book value when US mortgage rates spiked in Q2. On the other hand, if interest rates drop fast, they suffer from a spike in the prepayment rate and contracting spreads. So basically if you are a holder of MBS you are vulnerable to fast movements in interest rates in either direction. These guys do a lot of hedging through interest rates swaps though. They will do OK as long as interest rates movements aren't much more than 25bp/quarter. Then if rates go up, the book value hit is countered by an improvement in the spread and hedging profits while if they fall, you get a book value improvement countered by narrowing spread and higher prepayments.

Banks deal with the problem by getting longer-term funding with things like covered bonds and by being active in the swaps market for hedging purposes.
The truth will set you free. But first, it will piss you off.
--Gloria Steinem
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Elastic
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miw, do you think that the money from QE is finding its way into the sharemarket?
If the banks are swapping their bonds for cash then they must be looking to park it somewhere. If it's not directly then surely it must be through secondary lending to investors in the sharemarket.
If this is true then a sharemarket crash will lead to huge losses in the banking system again.
I just can't see a smooth ending to QE.
Not only will it lead to a rise in bond yields it will also cut off this injection of money into the sharemarket as the banks go back to buying bonds.
Only a rat can win a rat race.

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miw
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Elastic
10 Oct 2013, 03:36 PM
miw, do you think that the money from QE is finding its way into the sharemarket?
If the banks are swapping their bonds for cash then they must be looking to park it somewhere. If it's not directly then surely it must be through secondary lending to investors in the sharemarket.
Sometimes I think it is, but mostly I don't think so. QE is funny in that it increases the monetary base but it does not increase the money supply. (well, at least this is the case if the Fed buys from banks. I can't prove it to myself in the case where the fed buys from non-banks so I still have some doubts there.) In other words, it just makes the money supply more liquid. For the money supply to increase you either have to have unfunded deficit spending or the banks have to lend money.

So some people argue that the banks are going to the repo market with their increased reserves and the cash from this is being put by others into the share market. There are others who say this can't happen. My personal opinion is that the stock market has risen because of QE mainly because QE gets rid of a hell of a lot of tail risk, and tail risk has a big impact on share prices, as the last couple of weeks demonstrate pretty well.

I am not being helped by the fact that hardly anyone seems to understand what is happening. A lot of the well-respected commentators seem to be even more confused than I am.

Quote:
 
If this is true then a sharemarket crash will lead to huge losses in the banking system again.


Not necessarily. Repos are secured against assets, and the banks make margin calls when the value of the assets drops. The banks' counterparty has to be wiped out before the bank suffers a loss. Guys like me who own shares in mReits will take it in the shorts before the banks lose a penny. And that's assuming the QE excess reserves are finding their way out in an increase in money on the repo markets, which is hotly disputed.

Quote:
 
I just can't see a smooth ending to QE.
Not only will it lead to a rise in bond yields it will also cut off this injection of money into the sharemarket as the banks go back to buying bonds.


I have no doubt that the ending of QE and its subsequent reversal (whether by roll-off or by sale of securities) will have some negative impact on share prices, if only for psychological reasons. Bad in the short term for shareholders, but the share market is not the economy.
The truth will set you free. But first, it will piss you off.
--Gloria Steinem
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Elastic
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Cheers. Thanks for your thoughts.
Only a rat can win a rat race.

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