( The textbooks state that the hedging - receiving fixed rates in swaps, narrowing swap spreads -is because of falling mortgage rates increasing the risk of mortgage refinancing. But in this environment 'refinancing' is, well I'm not sure what it is. One side of the trade when swap spreads tightens is declining private risk. The other side , heretofore heretical, is increasing sovereign risk.- AM)
By Liz Capo McCormick and Dan Kruger
Nov. 25 (Bloomberg) -- The spread between the rate to exchange floating for fixed interest payments and Treasury yields over two years narrowed the most since 2003 after the Federal Reserve committed up to $800 billion in additional funds to unfreeze credit markets.
The difference between the two-year swap rate and the benchmark Treasury note yield, known as the swap spread , narrowed to 94.5 basis points from 112.25 yesterday. The 17 percent drop is the biggest one-day decline since September 2003.
As part of the Fed's new plan it will purchase as much as $600 billion in debt issued or backed by government-chartered housing-finance companies. Today's announcement follows the final details issued on Nov. 21 of the Federal Deposit Insurance Corp., known as the FDIC, plan to guarantee debt.
"Swap rates have traditionally been higher than Treasury yields in part because the floating payments are based on interest rates that contain credit risk,. Swap rates serve as benchmarks for many types of debt often purchased with borrowed money, including mortgage-backed securities and auto-loan securities.
Mortgage Spreads Collapse
The central bank's plan helped spreads on the more than $4.2 trillion of mortgage bonds guaranteed by Fannie and Freddie to collapse today, which triggered hedgers to receive fixed rates in swaps, narrowing swap spreads. Investors holding mortgage securities often use swaps and Treasuries to hedge the risks of swings in interest rates.
The yield premium, or spread, on the so-called current coupon 30-year fixed-rate mortgage securities guaranteed by Fannie Mae, over the benchmark U.S. 10-year note narrowed to 175 basis points, from 209 yesterday, data compiled by Bloomberg show. The spread helps determine interest rates on typical new home loans.
"Fannie Mae's current-coupon 30-year mortgage-backed security, which is tightly correlated on a spread basis to Freddie Mac's weekly survey of consumer mortgage rates, has fallen about 38 basis points," said Tony Crescenzi, chief bond strategist at Miller Tabak & Co. in New York. "That means that the 30-year mortgage rates are likely to fall a similar amount. If they do, it would bring the average rate to 5.66 percent, its lowest since January when the average 30-year mortgage rate was 5.48 percent."
Movements in mortgage rates triggered so called convexity- related hedging from holders of mortgage-backed securities, resulting in demand to receive fixed rates in swaps, which narrows swap spreads. This hedging is because falling mortgage rates increase the risk of mortgage refinancing, which reduces bond holders' duration.
Duration is a measure of bond price sensitivity to interest-rate change. Convexity is a measure of the rate of change of a bond's duration because of interest rate movement.