Interest rates fell precipitously, if erratically, from mid-2000 through mid-2003. Over that period, the yield on the ten-year maturity U.S. Treasury Note declined from 6% to 3.5%. Since traditional thirty-year fixed-rate mortgages are typically priced off the ten-year area of the curve, mortgage interest rates experienced a similar, but smaller rally. This led to an unprecedented wave of refinancing. As a result, holders of mortgage-backed securities (MBS) experienced the painful consequences of negative convexity*. One manifestation of the negative convexity of MBS is the tendency of price increases to decelerate as yields fall. This tendency limits total return. Over the last three years, we saw that the faster interest rates fell, the faster outstanding mortgages were refinanced. In technical terms, as interest rates fell, duration contracted. In the end, investors holding mortgage-backed securities were forced to reinvest principal prepayments at much lower interest rates.

Mortgage-backed securities represent a large proportion of the fixed income universe. As of June 30, 2003, MBS represented about 34% of the Lehman Brothers Aggregate Bond Index, a proxy for the universe of investment grade bonds. Because this index is so widely used by market participants, portfolios managed against this benchmark typically include a comparable MBS allocation. The decline of mortgage interest rates over the last three years to levels not seen since the 1950s may have positioned some MBS investors for a dramatic and largely unanticipated duration extension over the next several quarters.

Since the end of June, investors have taken a more constructive view of the prospects for the U.S. economy. In that brief time, the yield curve has steepened and interest rates have risen for all but the shortest maturities, which have been anchored by the Fed Funds rate. The yield on the ten-year Treasury Note has already risen over 100 basis points from its low in June. This development will substantially reduce the number of attractive mortgage refinancing opportunities. However, this development again exposes investors to the consequences of negative convexity. In this instance, as interest rates rise and refinancing activity recedes, MBS investors will find that portfolios have lengthened because pre-payments are much lower than expected. As duration extends, the price of mortgage-backed securities could fall more rapidly than prices in other fixed income sectors.

When interest rates fluctuate within a narrow band and mortgage prepayments are steady and predictable, MBS often provide investors with a substantial yield enhancement to compensate for the embedded prepayment options. (This option is the borrower’s ability to repay the mortgage at any time.) However, at times when interest rates move more sharply, either up or down, the pricing of mortgage-backed securities may not adequately compensate investors for the volatility risk they assume. Currently, we believe that valuations are such that investors are inadequately compensated for the duration extension risk in the mortgage market. Consequently, we are currently avoiding any exposure to mortgage-backed securities in client portfolios.

* Convexity is the mathematical relationship between a bond’s yield and price. As yield falls, price rises. The further yield falls, the faster the price rises.