This week’s implied forecast has been prepared while intense negotiations continue on the debt ceiling of the United States of America. One month Treasury bill yields have jumped in response, from 1 basis point on September 23 to 25 basis points on October 10, as shown in the following graph:
Credit default swap trading on the United States of America has also jumped from a period of relative slumber to one of moderately high activity for a reference name that ranked only 358th in contract volume over the 3 years ended June 28, 2013. After zero trades in 3 of the last 7 weeks, trading volume in CDS on the United States of America has increased to 87 contracts. While this is well below previous trading peaks over more than 250 contracts, it does show a rising difference of opinion among market participants about the credit quality of the United States of America as standard CDS contract language defines “default.”
The latest implied forward rate forecast from Kamakura Corporation shows projected 10 year U.S. Treasury yields up 0.01% to 0.09% from last week while fixed rate mortgage yields varied by up to 0.04%. Mortgage yields, determined by the Monday through Wednesday weekly survey of the Federal Home Loan Mortgage Corporation, lag Treasury movements simply because of the 3-day yield calculation used in the Primary Mortgage Market Survey ®. The 10 year U.S. Treasury yield is projected to rise from 2.71% at Thursday’s close (up 0.09% from last week) to 3.147% (down 0.08% from last week) in one year. The 10 year U.S. Treasury yield in ten years is forecast to reach 4.591%, 2 basis points higher than last week. The 15 year fixed rate mortgage rate is forecast to rise from the effective yield of 3.41% on Thursday (up 0.020% from last week) to 3.866% (up 0.026% from last week) in one year and 5.77% in 10 years, down 0.030% from last week. We explain the background for these calculations in the rest of this note, along with some mortgage servicing rights metrics. The forecast allows investors in exchange traded U.S. Treasury funds (TLT) (TBT), total return bond funds (BOND), municipal bonds (NUV) and exchange traded mortgage funds (REM) to assess likely total returns over the next 120 months. Treasury-related exchange traded funds affected by the forward rates include:
Long-duration Treasury Exchange-Traded Funds: TLH, TLT, IEF, DTYL, DLBL, ILTB, TENZ, ITE, TLO, EDV, VGIT, VGLT, TMF, TYD, LBND, UBT, UST, TMV, TYO, DSTJ, DSXJ, SBND, PST, TBT, DTYS, DLBS, TBF, TTT, TYNS, TYBS, TBX
Shorter-duration Treasury Exchange-Traded Funds: SHY, SHV, IEI, BIL, TUZ, FIVZ, DTUL, VGSH, DTUS, DFVS, DFVL, SST, ISTB, TBZ.
Today’s forecast for U.S. Treasury yields is based on the October 10, 2013 constant maturity Treasury yields that were reported by the Board of Governors of the Federal Reserve System in its H15 Statistical Release at 4:15 p.m. Eastern Daylight Time October 11, 2013. The forecast for primary mortgage market yields and the resulting mortgage servicing rights valuations are derived in part from the Federal Home Loan Mortgage Corporation Primary Mortgage Market Survey ® made available on the same day.
The U.S. Treasury “forecast” is the implied future coupon bearing U.S. Treasury yields derived using the maximum smoothness forward rate smoothing approach developed by Adams and van Deventer (Journal of Fixed Income, 1994) and corrected in van Deventer and Imai, Financial Risk Analytics (1996). The primary mortgage yield forecast applies the maximum smoothness approach to primary mortgage market credit spreads, which embed the risk neutral probabilities of mortgage default and prepayment risk. References explaining this approach are given below.
Both forecasts, plus the mortgage servicing rights parameters, are available via Kamakura Risk Information Services: Treasury Yield Service, Mortgage Yield Service, and MSR Valuation Service. For information, please contact Kamakura Corporation at firstname.lastname@example.org. Similar forecasts for the marginal cost of bank funding and the Libor-swap curve are also available on request.
U.S. Treasury Yield Forecast
This week’s projections for the 1 month Treasury bill rate (investment basis) have even more variation on the short end than last week, resulting in the twisting curves illustrated below. The projected 1 month rate of 4.474% in September 2023 is down 3 basis points from last week. The 10 year U.S. Treasury yield is projected to rise steadily to reach 4.591% on September 30, 2023, 2 basis points higher than projected last week.
Mortgage Valuation Yield Curve and Mortgage Yield Forecast
The zero coupon yield curve appropriate for valuing mortgages in the primary mortgage market is derived from new issue effective yields reported by the Federal Home Loan Mortgage Corporation in its Primary Mortgage Market Survey ®. The maximum smoothness credit spread is produced so that this spread, in combination with the U.S. Treasury curve derived above, correctly values new 15 year and 30 year fixed rate mortgages at their initial principal value less the value of points. The next graph compares the implied 15 year fixed rate mortgage yield with the implied 15 year U.S. Treasury fixed rate amortizing yield over the next ten years.
The effective yield on 15 year fixed rate mortgages is projected to rise from 3.411% today to 5.766% in 10 years, down 3 basis points compared to last week. The 15 year fixed rate mortgage spread over 15 year amortizing Treasury yields is forecasted to widen from its current level of 0.881% to 1.202% in 10 years, down 4 basis points from last week.
Implied Valuation of Mortgage Servicing Rights
Using the insights of Kamakura Managing Director of Research Prof. Robert Jarrow noted below, we have derived the risk-neutral values of mortgage cash flows which are based on market implied default risk and prepayment risk. We use these zero coupon bond prices to value mortgage-related cash flows relevant to mortgage servicing rights. These zero coupon bond prices, when multiplied by current primary mortgage market terms, value new mortgages at their principal value less the value of points:
Today’s implied mortgage valuation yield curve results in the following risk-neutral valuation split between interest-only and principal-only cash flows:
We apply the same mortgage valuation yield curve zero coupon bond prices to various levels of net servicing fees to get their risk-neutral present value in today’s market:
If we use the market convention that the net cost to service is a constant dollar amount, the risk-neutral present value of the net cost to service can be derived using the same zero coupon bond prices from the mortgage valuation yield curve.
Kamakura Corporation works with clients on a consulting basis to do this valuation on a risk-neutral inflation adjusted basis as well as the constant nominal dollar cost basis.
Next, we value float per $100 of taxes and insurance on the underlying home. We assume that float is invested at the matched maturity U.S. Treasury forward rate for the matching float period below. The risk-neutral present value of the interest earned is calculated using the mortgage valuation yield curve, since an event of default or prepayment on the underlying mortgage ends this source of value.
Value for a constant $100 amount is given here for “float periods” ranging from 1/4 of a month to a full month:
Again, the same analysis can be done on an inflation adjusted basis with insurance and taxes tied to the value of the home.
The value of float on the payment of interest and principal for various lengths of the “float period” is given in this table:
Another important component of mortgage servicing rights valuation is the net impact of cash flows to the servicer from the events of default and prepayment. We can analyze this by asking this question: what would be the value of the mortgage if there were no events of default or prepayment? The answer is obtained by applying U.S Treasury zero coupon bond rates to the scheduled mortgage cash flows. This table shows the net reduction in certain monthly cash flow that would be necessary for the value of the mortgage to adjust downward from this “no default/no prepayment value” to its current market value, discounted by the U.S. Treasury zero coupon bond prices. This adjusted basis converts the random probability of losses from prepayment and default to a known, certain cost of prepayment and default in the form of this “implied net constant monthly cash flow reduction.” The division of this negative cash flow impact between the servicer and other parties depends on the term of the servicing contract:
Background Information on Input Data and Smoothing
The Federal Reserve H15 statistical release is available here:
The Kamakura approach to interest rate forecasting, and the maximum smoothness forward rate approach to yield curve smoothing is detailed in Chapter 5 of van Deventer, Imai and Mesler (2013).
van Deventer, Donald R., Kenji Imai and Mark Mesler, 2013, Advanced Financial Risk Management, 2nd edition, John Wiley & Sons, Inc., Singapore.
The smoothing process for the maximum smoothness credit spread, derived from coupon-bearing bond prices, is given in Chapter 17 of van Deventer, Imai and Mesler (2013).
The problems with conventional approaches to mortgage servicing rights valuation and Kamakura’s approach to mortgage valuation yield curve derivation are also outlined here, along with the reasons for smoothing forward credit spreads instead of the absolute level of forward rates for the marginal bank funding cost curve.
The academic paper outlining the Kamakura approach to mortgage yield curve derivation was published in The Journal of Fixed Income:
Jarrow, Robert A. and Donald R. van Deventer, “A Simple, Transparent and Accurate Mortgage Valuation Yield,” The Journal of Fixed Income, Winter 2013, Vol. 22, No. 3, pages 37-44.
The mortgage valuation yield curve insights depend heavily on this important paper:
Jarrow, Robert A., “Risky Coupon Bonds as a Portfolio of Zero-Coupon Bonds,” Finance Research Letters, 1, no. 2 (June, 2004) pp. 100–105.
Today’s Kamakura U.S. Treasury Yield Forecast
The Kamakura 10 year monthly forecast of U.S. Treasury yields is based on this data from the Federal Reserve H15 statistical release:
The graph below shows in 3 dimensions the movement of the U.S. Treasury yield curve 120 months into the future at each month end:
These yield curve movements are consistent with the continuous forward rates and zero coupon yields implied by the U.S. Treasury coupon bearing yields above:
In numerical terms, forecasts for the first 60 months of U.S. Treasury yield curves are as follows:
The forecasted yields for months 61 to 120 are given here:
Today’s Kamakura Forecast for Effective Primary Mortgage Market Yields
Today’s forecast for the mortgage valuation yield curve is based on the following data from the Federal Home Loan Mortgage Corporation Primary Mortgage Market Survey ®:
Only fixed rate mortgage data is used in this analysis for reasons explained in the Kamakura mortgage valuation blog.
Applying the maximum smoothness forward rate smoothing approach to the forward credit spreads between the mortgage valuation yield curve and the U.S. Treasury curve results in the following zero coupon bond yields:
The forward rates for the mortgage valuation yield curve and U.S. Treasury curve are shown here:
The numerical values for 360 months of zero coupon bond prices and yields for the mortgage valuation yield curve are available by subscription to the KRIS Mortgage Yield Service via email@example.com. For comments, questions, or more information about the yield curve smoothing and simulation capabilities in Kamakura Risk Manager, please contact us at firstname.lastname@example.org. Kamakura interest rate data are available in electronic form in both general and Kamakura Risk Manager data base format.
Taqui Raza, Donald R. van Deventer and Martin Zorn
Honolulu, October 11, 2013
Revised and updated with lessons from the 2007-2010 financial crisis, Advanced Financial Risk Management outlines a framework for fully integrated risk management and is an essential resource for anyone working in the financial field.