By Malay Bansal

The overlooked reason behind the U.S. Treasury yield’s seemingly irrational behavior.

2014 started with ten year treasury yield at 3% and almost universal expectation that it was going nowhere but up from there (Treasury Yield Forecast for 2014 Climb to Survey High of 3.41%). Yet, confounding everyone, it has done exactly the opposite. Defying everyone’s expectations, it has steadily gone down since the beginning of the year and has been around 2.50% recently!

The underlying logic for expecting yields to go up is sound. As expected, the economy is slowly but surely improving. GDP has been growing. The unemployment rate is coming down. All 8.7 million jobs lost during the recession have been gained back. The unemployment rate is down to 6.2% from 10.1% in 2009. Even underemployment (U6) is coming down and is below 15% now, down from 17.5% during the recession. Inflation numbers are firming. Stock markets are back to previous highs. Real estate prices have recovered a lot of the ground lost during the recession. With the economy improving, and asset prices going up, yields should not be at such low levels.

Also, as expected, the Federal Reserve is tapering its bond buying program (QE3), and is going to end it by October this year. Under QE3, the Federal Reserve was buying $45 billion of treasuries (and $40 bn of mortgage bonds). With QE3 ending, a big source of demand is going away, which is another reason for yields to go up.

All rational logic suggests that yields should have gone up this year, not down! So, does the fact that yields have come down instead indicate an irrational behavior on the part of bond buyers? The behavior clearly has the experts baffled (see U.S. bonds confound experts as yields fall, Street baffled as 10-year bond yields hit lowest in six months, Cramer: Baffled by where interest rates are – CNBC).

Several different explanations have been provided by market experts for this (see Why the World Still Loves U.S. Treasury Debt, Bill Gross says this is what’s really behind the Treasury rally). However, in my opinion, one key reason has not been recognized or understoodthe role played by increased availability of information, a concept I refer to as Information Momentum (see Using Information Momentum to Understand Markets & Economy), which has a big impact on behavior of market participants.

To understand the link between the two, consider that the signs of improvement in the economy and job market are clear and evident. Everyone can see that the economy is improving and asset prices have gone up. Though forecasts have come down, yields are still expected to go up from here. Almost everyone believes that rates will be higher in future, although most people also believe that yields are not going up immediately and the start of rate increases is a few months away at the least, as the Federal Reserve has clearly stated that it intends to keep interest rates low for a “considerable time” after ending bond purchases. With the easy availability of information, most people (including, and especially, professional investors and bond buyers) believe that they will know when the rates start moving and will be able to act quickly. The changes at Fed to be transparent in its communications started by Ben Bernanke have had a positive effect generally by reducing uncertainty, but as a result, everyone has higher confidence in their ability to know when the Fed will act to raise rates. It is an obvious and well-recognized fact that when yields go higher, bond values will go down. People will reduce their bond holdings once yields start going up and portfolios start showing losses. However, they do not perceive a need to act now. Compared to the past, a lot more people now, have a lot more confidence in their ability to know quickly and act at the last minute (“Just-in-time decision making”) when yields really start going up. This is an important reason why market participants have not acted on their belief that yields will be higher in future, and that lack of action has resulted in the yields staying lower than they otherwise would be.

If you agree with the above logic, the lower yields are not a result of irrational behavior on the part of market participants, but just a manifestation of change in timing of their actions. Also, there are important implications for future. If everyone believes that they can act at the right moment and do not have to act earlier than that, and most people have the same sources of information, then that means, a lot more people will come to same conclusion at the same time. That will lead to a lot more people acting at the same time. If a lot more people are trying to sell their bonds (or bond funds) at the same time, it will result in a sudden big jump in yields. We saw an example of this in May-June 2013 when 10 year yields jumped up by over 100 bp in a span of two months!

It also has important implications for the Fed. In the past, with somewhat cryptic Fed-speak, which left people guessing on the timing of rate increases, different people had different opinions on timing of rate increase based on their differing interpretations of the Fed pronouncements. That moderated the speed at which the yields moved higher as some people acted earlier than others. This time, Fed’s transparency makes more people more confident they know when rates will start going up, increasing the risk of sudden jump in yields, which can be bad for the economy and markets. Janet Yellen (whose husband, George Akerlof, a University of California, Berkeley, professor, won the Nobel Prize in economics in 2001 and played a role in behavioral economics) and the Fed have their work cut out for them to manage the rate at which yields go up. Actions from the Fed that will raise doubts about timing of rate hike will actually be helpful in this regard. It will not be surprising to see more members of the board dissenting and offering differing opinions, which is one way to introduce some doubt about the timing of the rate increase.

The other thing that the Fed can do to moderate the speed of rise in yields is to adjust their timing to when there is higher demand for U.S. treasuries. Since the US economy is a little ahead of Europe and other developed nations in recovery, the US Dollar is seen to have a positive outlook compared to other currencies. That attracts capital to US treasuries. As other economies recover, the relative attractiveness of the dollar may lessen. This would suggest that Fed will be better off raising rates sooner than later, if the economy continues improving.

Complicating Fed’s decision is the risk of derailing the growth by hiking rates too early, which may cause the Fed to delay action. However, the delay will probably mean a bigger and faster rate rise when they do start raising rates.

The conclusion on the outlook for rates is similar to that in my article (What’s Ahead for US Interest Rates?) last year, though economy has improved measurably since then and is undoubtedly growing. As the economic growth picks up or inflation rises, yields will go higher, and even though it is difficult to predict when yields will start increasing, it is easy to see that when yields do start increasing, the increase could be very rapid and significant. The implications for investors are (i) to not wait till the last minute, but act sooner to adjust positions and portfolios, and (ii) be careful when using strategies that depend on the timing of yield increases to be right.

Note: The views expressed are solely and strictly my own and not of any current or past employers, colleagues, or affiliated organizations.

LTV and DCR Are Not the Only Determining Factors for Defaults on Commercial Mortgages

Note: This article was originally published in Winter 2014 issue of  CREFC World Magazine published by the Commercial Real Estate Finance Council.

Steve Guggenmos, Senior Director, Freddie Mac
Jun Li, Director, Freddie Mac
Yu Guan, Analyst, Freddie Mac
Malay Bansal, Senior Director, Freddie Mac

For simplicity, some models used by CMBS investors assume that the non-recourse borrower will default immediately if the DCR falls below 1.0 or LTV goes above 100 (percent). This is sometimes referred to as “ruthless default” behavior. In reality, however, borrowers do not choose to default just because DCR is below 1.0 or LTV is higher than 100. This article examines some historical data and attempts to look at various factors that have an impact on the borrower’s decision to default, and presents historical default rates for each category.

Using different default rates for the different categories may be a better approach for scenario analysis for CMBS investors than trying to use fixed cutoff numbers for DCR and LTV to examine each loan to determine if it will default or not.  An important underlying factor that motivates borrower behavior is the option value embedded in owning the real property.

Also, borrower selection impacts ruthlessness.  Market expertise helps borrowers measure the benefits of supporting an underperforming property based on potential future upside.  Further, key to the decision to support the property is the borrower’s access to capital and overall liquidity – without which there is no ability to subsidize the property until the market improves.


As part of their investment analysis, CMBS Investors run various scenarios of changes in economic conditions, cap rates, vacancies, NOIs, etc. The resulting DCR and LTV are used to decide if the loan will default in that scenario and what the loss severity will be in case of default. If DCR falls below 1.0, that clearly increases the likelihood of default during the loan term as borrowers are required to pay out-of-pocket to cover property expenses.  When the property value is below the loan amount default is more likely and losses will be higher in case of default. Also, if the LTV is above 100 at maturity, the loan is not likely to not qualify for a new loan without putting more equity into the property, and hence there may be a maturity default.

In practice borrowers do not choose to default just because DCR is below 1.0 or LTV is higher than 100. There is an option value to owning real property that impacts borrower behavior. The option value captures the possibility of upside in the future.

Investors are aware of the option value. However, if 1.0 DCR and 100 LTV are not the cut off points, what are the levels that drive borrower behavior? Even more complex models must address this question as well. In this research we focus on the multifamily loans and look at the borrower default behavior in loans in both CMBS and Freddie Mac collateral.

See full article at: Freddie Mac Research page, or CREFC World website.

By Malay Bansal

Where are US Treasury yields headed and how fast could they move.

Note: A version of this article was also published on Seeking Alpha.

In early February, the U.S. Treasury made a statement that has not received much attention even though what it implies regarding their thoughts on the future demand for treasury securities (and hence yields) is very interesting. The announcement was mainly about the auction of $72 billion of coupon securities, but it also said that it plans to issue a final rule on floating-rate notes in the coming months, with the first FRN auction expected to occur within the next year. The statement probably did not get a lot of attention because the Treasury has spoken about the idea of floating-rate notes earlier too. However, it had never given a specific time frame in the past. This is significant, not just because it will be first new type of treasury security to be issued since 1997 when the U.S. government introduced TIPS or Treasury inflation-protected securities, but also because what the need for the Treasury to issue these at this time implies about their view on interest rates.

The details on the floating rate notes still need to be worked out. Treasury hasn’t chosen the index to use, and is considering the Treasury 13-week bill auction high rate, Treasury general collateral overnight repurchase agreement rate, etc. All of these will make Treasury’s financing cost variable and expose it to the risk of higher costs in future if the index moves higher.

At a time when yields are low, what is the need to introduce a new security that can result in higher costs as rates increase?  The only reason to introduce something that may result in higher cost for debt is the worry that there may not be enough buyers for fixed rate Treasury debt once yields start increasing. With trillion dollar budget deficits and need to refinance maturing debt, if there are not enough buyers, the lower demand will naturally result in yields moving higher quickly.

How much will rates move?

There is almost universal expectation that yields are going higher. Numerous reports and articles over the last few months have mentioned expectations of higher yields and concerns about the risks to investors holding fixed rate debt from various market participants (examples:  Barron’s, Bank Of America, PIMCO,  Financial Times).

In December 2012, when the 10-year treasury yield was 1.71%, the median forecast from all the 21 primary dealer banks of the treasury market was for the 10-year yield to rise to 2.25% at the end of 2013. In Feb 2013, economist Mark Zandi of the widely used offered  “Treasury yields are on track to yield as much as 5% in three years,” (though he caveated his forecast with his assumption of Washington taking the right steps). Bloomberg survey puts the current forecast for 10-year treasury yield to rise from 1.66 at present to 2.25 at end of 2013 and 2.73 at the end of 2014. For 30-year bond yield, the survey predicts yields to rise from the current 2.86 to 3.40 by end of 2013 and 3.82 by end of 2014.

The rationale for rising yields is clear. Easy monetary policies and quantitative easing from central banks around the world are meant to inflate asset prices. How could such large scale of printing money to buy bonds not result in inflation at some point? The economy is slowly improving. And yields are at historical low levels.

The 10-year note yields just 1.66%, 5-year note yields a mere 0.68%. Even the 30-year long bond yields just 2.86%. These puny yields expose bond holders to significant risks if yields rise. For the 10-year note, a 50 basis point increase in yield within the next year will result in price decline of about 4.5%, significantly more than the 2% coupon income. The 5-year note will not do that much better – a 50 bp increase in yield would decrease price by 2.5%, far more than the 0.625% coupon. The 30-year long bond will obviously be hurt the most with its longer duration. A 50 bp rise in yield will result in 9.8% decline in price far outweighing the 3% coupon.

If you expected 10-year yields to increase by 100 bps in next 2 years (forecast mentioned above is a rise from current 1.66 to 2.73 or 106 bps by end of 2014), you would lose about 9% in price and earn 4% in coupon. Would you buy at 1.66 yield or wait for yields to rise to 2.73? To buy the notes now, buyers would want a yield closer to 2.73 now, causing an immediate jump in yield. If you expect yields to rise even more, say 5% after another couple of years, would you even buy at 2.73? As expectations of higher yields take hold, the Treasury will have to immediately pay higher yield reflecting future expectations to entice buyers. This will push yields up quickly towards the expected highs. Given how low yields are, the amount and speed of increase could be significantly higher than in the past. Once yields start increasing, the increase will be further exacerbated by selling from holders of pre-payable mortgage backed securities to hedge their increasing durations (convexity hedging which results from the fact that as yields increase, prepayments on mortgages decrease resulting in higher durations which requires selling of treasuries or swaps to hedge the increase in duration).

Floating rate notes do not have the interest rate risk of fixed rate bonds. So investors are not likely to demand the risk premium that they would need for fixed rate bonds. That is the rationale for the Treasury to issue Floating rate notes.

Are Yields the Easiest Shorting Opportunity of a Lifetime?

Yields are near historical lows and are universally expected to go up. With that, are US yields the easiest shorting opportunity in the market? Not really. As with people sometimes, markets say and do different things and it is important to see what they are doing rather than what they are saying. In this case, if everyone is completely convinced that yields will be higher, why would anyone buy treasuries at these low yields at all? Some of the buying could be attributed to some retail investors not being aware of potential for yields to rise or not being mindful of the risk, or their positions being inconsistent with their beliefs. Some of it could be attributed to flight for safety. However, the fact that yields are near the lows is more an indication of a lack of conviction among larger investors about the rates rising quickly and significantly. The expected inflation over 10 years as implied by yields on 10-year notes and TIPs, at about 2.40, is in the middle of the range of 2.10 to 2.60 for the past year. CPI, at 1.5%, is near the lower end of 1% to 4% range of past three years. Gold prices are lowest they have been in two years. Oil price, at 93, is in the middle of the 85 to 105 range over the last three years. These do not show an obvious immediate concern for inflation. The market is doing something different from what people in it are saying and expecting.

What about the polls predicting higher yields? Interest rates are very hard to predict, even for very smart people. Rates have been low for 5 years now. When they dropped initially, almost no one expected them to stay this low for this long. A look at polls and forecasts from past might also be instructive in that regard. In a poll of Primary Dealers in Jan 2011 the median of forecasts from 17 of 18 primary dealers was for the 10-year note yield to climb from 3.33 percent at that time to 3.50 percent by the end of the second quarter of 2011. The average prediction in a Dec 2011 poll was for 10-year yield to rise from 1.85 at the time to 2.74 by end of 2012 (actual 2012 year-end yield was 1.76).

Even if you do see a bubble in yields ready to pop, getting the timing right can be almost impossible. The lower US yields have persisted for 5 years now even though everyone agrees they should be higher. The Japanese Government Bond market has crushed many investors who tried to short it (the widowmaker trade) and provides an example of the difficulty.

Yields could bounce around in the range they have been in recently (1.60 ish to slightly above 2%) for a far longer time than expected, unless the economy improves quickly or inflation picks up.

What to Look Out for?

The direction of interest rates depends most on the economy and what Fed does with QE program and fed funds rate. One of the most important indicators will be any sign that Fed is beginning to pull back on its $85 billion a month bond purchase program. That will happen before Fed actually starts increasing Fed Funds target rate. Federal Reserve’s decision, in turn, will be based on progress in employment situation, which thus becomes one of the most important indicators.

The Federal Reserve has said that it expects to maintain short-term interest rates near zero, even after it stops buying bonds, for as long as the unemployment rate remains above 6.5 percent, provided that medium-term inflation does not exceed 2.5 percent. A good read on this is an article on PIMCO website which also includes a list of 10 employment related indicators the Fed is watching (Telling Tape Time, Tony Crescenzi, April 2013).


The U.S. is not Japan. Our policy makers have learned from the Japanese experience and have not followed the same path. Also, the economy is showing signs of improvement, though more in some sectors than others. As the economic growth picks up or inflation rises, rates will increase. However, exact timing of that increase is difficult to predict with any type of certainty. Yields could bounce around in the range they have been in recently (1.60 ish to slightly above 2%) for a far longer time than expected, unless the economy improves quickly or inflation picks up. Any strategies or positions taken that depend on rates rising within a certain time frame carry a risk even though the view on the direction may be correct.  Even though it is difficult to predict when yields will start increasing, it is easy to see that when yields do start increasing, the increase could be very fast and significant.

Note: The views expressed are solely my own and not of any current or past employers or affiliated organizations.


%d bloggers like this: