Prepayment Risk Concerns? Derivatives Can Help

Interest rate volatility continues to hover near historic levels. With the 10-year Treasury yield around 3.5% and new production 30-year mortgages nearly at 7%, the spread between the two remains at levels not seen since the financial crises, except briefly at the start of the COVID-19 pandemic.

This increased spread provides a cushion and essentially hedges a credit union against higher rates, to a certain degree. Assuming the interest rate volatility begins to normalize, and if the 10-year Treasury remains around 3.5%, the spread between the 10-year Treasury and the 30-year mortgage rate should contract as liquidity/credit concerns abate.

Risk exposure and rates

When considering interest rate risk exposure, it’s important to evaluate whether the Fed is done raising rates. If not, how high do rates need to rise to accomplish the Fed’s goals? If rates increase accordingly, how much more will mortgage rates rise?

If term investors remain comfortable with future inflation prospects combined with a strong chance the Fed keeps its policy rate around 5.25% for some time, the curve should remain inverted. In turn, the 10-year Treasury yield would have to rise significantly to make a dent in the valuations new 7% 30-year mortgages. Obviously, higher rates carry risk, but is that where most of the current interest rate risk currently sits?

Lower interest rate risk

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 prepay their 7% mortgages and finance at a lower rate. Assuming those homeowners all refinanced with your credit union, your credit union could lose 100-150 basis points on a long duration asset, reducing your interest income.

The market currently disagrees with the Fed and thinks the Fed should start to ease in July to head off a recession. If a recession occurs, rates will most likely decrease to stimulate growth. In turn, homeowners will prepay their mortgages. Earning assets will enter the books at lower rates, resulting in realized prepayment risk.

Which direction of interest rate risk is more concerning?

Although not definitive, the risk appears to be somewhat biased toward lower rates and prepayment risk. Mentioned above, there is already a large spread, and the market remains certain we are headed into a recession. Therefore, one of the best ways to hedge mortgage prepayment risk is with interest rate options. The nonlinear nature of interest rate options causes their payoff profiles (valuations) to match up better against other interest rate derivatives used to exposure to lower rates.

Regarding what type of options to use, an efficient structure to hedge against prepayment risk is to buy an option(s)to enter an interest rate swap at a future date. The underlying swap has a credit union receiving fixed payments for the life of the swap, while paying a floating leg, such as SOFR. These receiver swaptions are often an effective hedge against lower rates and mortgage prepayments.

Catalyst Strategic Solutions can evaluate your potential interest rate risk and provide solutions for minimizing it in your mortgage portfolio. Interest rate derivatives are a flexible and customizable tool to help meet specific balance sheet hedging needs. To learn more, visit the Catalyst Strategic Solutions Derivative Hedging Services webpage.

Mark assists client credit unions in meeting their goals in the areas of financial management, ALM analysis, investment portfolio analysis and strategic planning. Prior to joining Catalyst, Mark worked for the Federal Home Loan Bank of Dallas for nearly 15 years. As Treasurer, Mark oversaw financial operations of the bank.