Tuesday, December 2, 2008

Convexity Trades Also Contributed to 30Y Trea lower Yield

Dec. 2 (Bloomberg) -- Thirty-year Treasury bonds are returning the most since 1995 as investors bet the Federal Reserve will buy the securities to help bring down long-term borrowing costs. The so-called long bond has returned 27.8 percent this year, including a 15.6 percent gain in November, Merrill Lynch & Co. index data show. The debt is poised for the best annual performance since rallying 34 percent 13 years ago. Yields touched 3.1825 percent yesterday, the lowest since the U.S. began regular auctions of the securities in 1977, after Fed Chairman Ben S. Bernanke said he has “limited” room to lower interest rates further below 1 percent and may use less conventional policies, such as buying Treasuries. Even investors who say bonds are expensive are enticed to buy the debt for fear of missing out on even more gains. ‘Convexity Trades’ Traders are also buying 30-year bonds on speculation the Fed’s purchases may drive mortgage rates lower, spurring homeowners to refinance their home loans and reducing the average maturity, or duration, of mortgage bonds. A sudden drop in duration can cause losses for mortgage investors because it means they are receiving their money back sooner than anticipated, forcing them to reinvest at lower rates. To hedge against losses and to increase the duration of their holdings, they’ll typically buy Treasuries. The yield on Fannie Mae’s 30-year current coupon mortgage securities fell 11 basis points to 4.72 percent yesterday, from 4.83 percent Nov. 28. “The ball got rolling last week,” said Chris Ahrens, an interest-rate strategist at UBS Securities LLC in Greenwich, Connecticut, one of 17 primary dealers that trade with the central bank. “The trade has fed upon itself with the continued weak economic information that we saw today.” Different (supply vs demand) circumstances caused historic low Yilelds The last time the 30-year bond rallied as much as it has this year was 1995, as optimism grew that the Clinton administration was poised to turn budget deficits into surpluses, allowing the government to reduce debt sales. Form a shortfall of $163.9 billion in 1995, the deficit narrowed each year until 2000, when the U.S. recorded a $236.9 billion surplus. This year’s surge comes amid different circumstances, as the government is expected to post a deficit in excess of $1 trillion as it attempts to fund bailouts for banks and fiscal stimulus programs to jump start economic growth.

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