By Mark Wert, Catalyst Strategic Solutions Senior Advisor
Interest rate volatility is hovering near historic levels. With the 10-year Treasury at 3.5% and new 30-year production at nearly 7%, spreads are at levels not seen since the financial crisis about 15 years ago, other than very briefly at the beginning of the COVID-19 pandemic.
This increased spread provides a cushion and can help credit unions hedge against higher rates, to a certain degree. Assuming the markets begin to normalize and the 10-year Treasury remains around 3.5%, the spread between the 10-year Treasury and the 30-year mortgage rate will contract as liquidity/credit concerns begin to abate.
Where are rates going?
When considering interest rate risk exposure, it’s important to evaluate whether or not
the Fed is done raising rates. If we assume they are not done, how high do rates need to rise to accomplish the Fed’s goals? If rates increase accordingly, how much more will mortgage rates rise?
Though these questions cannot be definitively answered, if term investors remain comfortable with future inflation prospects, the curve should remain inverted. In turn, the 10-year Treasury rate would have to rise significantly to make a dent in a 7% 30-year new production valuation. Obviously, higher rates carry risk, but is that where most interest rate risk occurs?
The risks of lower interest rates
Owners of mortgage loans need to be mindful of both higher and lower rates. If rates drop, homeowners making up the new production on the books would look to refinance. Therefore, homeowners would prepay their 7% mortgages and finance at a lower rate, such as 5.5% or 6%. Assuming those homeowners all refinanced with your credit union, your credit union would lose approximately 100-150 basis points in carry on a long duration asset, reducing your interest income.
As mentioned above, the spread between 10-year Treasury yields and 30-year mortgages could also contract. This scenario would also lead to increased prepayments. So, owning new production has brought in more spread, liquidity and bank risk premium than during normal times.
Regarding risks to lower rates, the market currently thinks the Fed has to cut rates, starting in July, to head off a potential recession. If a recession occurs, rates will most likely decrease in order to stimulate growth. In turn, homeowners will prepay their mortgages, leading to earning assets entering the books at lower rates, resulting in realized prepayment risk.
Which direction of interest rate risk is more concerning?
The risk appears to be somewhat biased toward lower rates due to prepayment risk sitting at levels not seen in two decades. One of the best ways to hedge mortgage prepayment risk, which is nonlinear, is with interest rate options. Due to the nonlinear profile of interest rate options, their payoff profiles (valuations) will match up better against other interest rate derivatives that could be used for hedging downside risk.
An efficient way to hedge against prepayment risk is to buy an option(s) to enter into a swap(s) in which your credit union receives fixed payment on an interest rate swap, while paying a floating leg, such as SOFR. These are called receiver swaptions. Although complexity increases when hedging with options, receiver swaptions are often an effective hedge against lower rates and their impacts on mortgage prepayments.
Reduce risk with your preferred derivatives partner
Catalyst Strategic Solutions can partner with your credit union to evaluate your potential interest rate risk and provide solutions for minimizing it in your mortgage portfolio. Interest rate derivatives are flexible and customizable, and they could be a useful tool to help you meet your specific balance sheet hedging needs. For more information, contact us today.