Hedging using bonds and bank bills

D

dptrading

Here's a question that was sparked by a previous thread. I want to take out a mortgage on a floating rate, which is sitting around 1% lower than the fixed rate equivalent, but since I believe rates are likely to rise over the next 20 years or so, I want to hedge the rate and lock it in. I tried to explore it at these links, but had some more questions. It essentially involves shorting bonds to offset rising rates with capital gains on the bond, or using bank bill futures to profit from rate decisions that lead to higher loan repayments.

http://www.pimmtrading.blogspot.com/2012/01/hedging-your-mortgage-rate.html

http://www.tradingpimm.blogspot.com/2012/01/bank-bills-and-government-bonds.html

These strategies involve futures, and is there a cost to roll over the futures contract? If so, how much per rollover? Being short bonds (for rising yields) significantly reduces the interest charge associated with the position, you wouldn't need a large position, and the bank bill approach involves very short term trades, but are there any other costs to consider if doing this?

Although the strategy may not be a 100% hedge, if the overall slippage is less than the 1% spread between the current fixed and floating rate, then it's worth doing, right?

Thanks in advance, David
 
Yes, there is a cost to roll over futures. You'll have to pay commish, spread, and there will likely be a cost differential between the expiring month contract and the next contract expiry.

To hedge against rising interest rates, I would look into shorting eurodollars:

<img src="http://www.elitetrader.com/vb/attachment.php?s=&postid=3411016" alt="some_text"/>
 

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Thanks for the quick reply and details. At least trading futures there is generally 0 commission and the spreads aren't too wide, so that's a good sign.

Why would you consider eurodollars a better hedge than government bonds (specific to the country that your mortgage is taken out in). As an Australian wouldn't the bond yield be more closely tied to my mortgage rate?
 
Didn't realize you were Australian. Yes, something tied directly to interest rates in Australia would be better in your situation.
 
Sure, that makes sense. I forget that I always have to put that in somewhere, it's easy to forget that we are significantly outnumbered.
 
If you do bank bills (IRs), you're running a lot of risk and your hedge is potentially worse. I'd look into the Aussie bond futs, if I were you (along the lines of what was suggested earlier). There's a lot of threads on the subject here, generally.
 
Most of the time when retail clients try to hedge rates on homes they run into two problems: If you want matching maturities you find you get little if any savings and if you try to dynamically hedge by using shorter term instruments you either get eaten up on the rollovers or worse you find yourself not quite hedged and get a bit of a nasty surprise as you try to bring it back in line.

While rates are not as good as in the US my guess is that rates around the world will seem cheap five and ten years down the road. If we (the world) sees deflation the central banks will print and it will at some point flip. If we skip the deflationary part of the cycle then we will likely go straight to inflation as there is tons of liquidity already provided for. The chances of rates going up are high and the chances of them moving up dramatically over years are more than one in ten.

Take all they will give you at a fixed rate or a variable with a cap you can live with. Over time it will probably prove to be a very timely move.
 
there is this bank borrowing in foreign currency issue. Who knows if/how banks hedge exchange rate risk but my gues is they dont fully. Combination of exchange rate and other ccy interest rate movements may push mortgage rates away from bill/bond rates in a big way.

If they borrowed yen heavily implications of interest rate rise in Japan may be magnified in AU. Go for fixed rate. I know it is higher rate but for a good reason.
 
Im not quite sure I understand the foreign currency bank example, how that would impact Australian bank rates, as retail banks are fully hedged most of the time so as not to risk falling out of line with the other lenders.

Taxes are a good point, capital gains tax would mean that rising rates (and therefore short bonds) would lead to an additional charge, but were rates to fall (less likely in Australia, but more likely here than in the US) then there would be a CGT gain to be made. This could be compensated for by adding to a profitable futures position (additional profit to help offset tax) and reducing a losing (rates going down) position to reduce the tax benefit.

Certainly makes it trickier, looks like www.pimmtrading.blogspot.com needs a part 2.

For the record, I would personally take the fixed rate, as the time it saves through not worrying about all this, and what is undoubtedly a low rate with a long term view, makes it preferable in my eyes.
 
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