With private credit rates generally lagging the liquid market rates, fluctuations in spread levels and valuations arise. While for traditional fixed income investors, this volatility in spread levels could indicate uncertainty related to the creditworthiness of the borrower, that’s not necessarily true for private credit investors. But how do these rate lags affect investors and especially, mortgage investors?

In our 2022-Q2 newsletter, we covered the high levels of inflation which lead to rapidly increasing interest rates. Private credit rates are generally lagging the liquid market rates precisely due to the illiquid nature of this market. This causes fluctuations in spread levels and valuations. For traditional fixed income investors, volatility in spread levels would indicate uncertainty around the creditworthiness of the borrower. This, however, does not need to be the reason for private credit markets. Only these fluctuations in spreads levels do affect investors in private credit that report these investments on market value rather than on an amortized cost basis since the liabilities of these investors are affected by liquid market rates. This then results in an imbalance in their assets and liabilities of which one can argue if this is a true imbalance or a temporary effect caused by the lagging private credit markets. In this article we investigate these rate lags for Dutch mortgages and the effects this may have on private credit investors.

Pricing in practice

In the Netherlands, there are roughly 45 mortgage lenders that are originating new mortgages via about 80 unique mortgage labels [1]. Each label publishes rates for different fixed rate periods (variable rate to 30-year fixed for most labels), different payment types (annuity, linear and interest-only) and for every risk segment (National Mortgage Guarantee [Dutch: NHG] or non-NHG for different LTV bands). Some mortgage lenders even have special rate discounts for energy efficient homes or clients that are also a banking client. Generally, a pricing committee is appointed to set these interest rates. Based on market developments, origination appetite and other potential restrictions or preferences, this committee sets its interest rates. Usually, this is performed on a weekly basis. This is a major reason for the lagging behavior of Dutch mortgage rates with respect to swap rates, which is most often used as a measure to determine spread, as swaps are traded throughout the entire day on the public markets. In addition to that, there is another reason for the lagging behavior of Dutch mortgage rates and that is related to the way the Dutch mortgage market operates. Consumers that want to take out a mortgage generally go to independent financial advisors to find them the most suitable mortgage product. These financial advisors can see the interest rates from multiple mortgage lenders in their computer systems, based on that give the borrower an indication of the amount that they can borrow given their income and their monthly installment given the current rates. Based on this information, the borrowers can place a bid on a house. In case the rate changes, the advisor demands mortgage lenders to inform them up front so that they can still apply for the loan at the rate that is currently applicable. Therefore, a lag is embedded in the pricing process to give the advisor this extra time. On the other hand, mortgage lenders do not want to price themselves out of the market completely. In case of rapidly rising swap rates, they therefore don’t want to increase market rates too quickly as this might result in very low offer volumes. To quantify the effect of lagging rates, we investigated the correlation of swap rate movements and mortgage rate movements over time.

Correlation analysis

To test our initial hypothesis of mortgages rates not moving simultaneously with swap rates, we perform a correlation test between daily movements in swap rates and mortgage rates for the period between 2014-08-01 and 2022-12-19. For our analysis we consider the swap rate for a 10-year swap against 6M Euribor and the 20-year rate for a 100% LTV non-NHG annuity mortgage which roughly match in terms of duration when taking prepayments for the mortgage loan into account. The mortgage rate is determined to be equal to the average rate for the top-6 lowest rates that are offered in this market segment for new origination, so excluding reset rates. The result of this analysis is displayed in Figure 1 below.

Our analysis shows that there is no significant correlation between the two rate movements as the p-value of our Pearson correlation test is 0.3211 (a p-value lower than 0.05 is significant given a 95% confidence interval). This confirms our hypothesis that on a daily basis, swap rates and mortgage rates do not move in parallel. So, if there is indeed a lag in rate movements as suggested by our hypothesis, we should be able to find a significant correlation between market rate movements and lagged swap rate movements. In order to investigate this, we perform a more comprehensive time lagged cross correlation analysis. The results of this analysis are shown in Figure 2 below.

We can see from the correlation coefficients in Figure 2 that lags are consistently significant and positive (as we would expect) between lag 7 and lag 41. Note here that we only consider working days for our analysis so that means that swap rate movements that take place 8 to 1.5 weeks prior to today may have an effect on today’s rate changes. However, the correlation coefficients are rather low as the highest value is 0.124, which is far from a perfect correlation which would give correlation coefficient of 1. The reason for this might be that the market consists of many different mortgage lenders which all have their own intervals when it comes to adjusting rates. So perhaps, looking at weekly rate changes rather than daily rate changes gives a more consistent view of the way swap rate changes affect mortgage rates as this also reduces noise in the data.

Figure 3 above shows the results of the correlation analysis for weekly rate changes and shows a much more consistent result as compared to the daily changes analysis. Also, the correlation coefficients are much higher, with the highest value coming in at 0.315. It should be noted that the lags shown here are overlapping since the weekly intervals are calculated on a daily basis. So not all lags are relevant. Besides the lag period over which we consider the rate changes, the time period in general is also important for our analysis. The Dutch mortgage market has become increasingly competitive over the years with new investors entering the market at a record pace. This has created a downward pressure on spreads, as is shown by the decreasing trend in spreads in Figure 4.

This effect also alters the relation between swap rate movements and mortgage rate movements. To try to quantify this effect, we reperform the weekly change analysis but for two time periods. As a cut-off point, we take 2019-01-01 as this is at the time where the clear downward trend becomes less consistent. For the two periods, the results of the correlation analysis are given in Figure 5.

The results in Figure 5 show a big difference in correlation between swap rate movements and mortgage rate movements for different time periods. As expected, the swap rate movements are to a lesser extent reflected in mortgage rates during the time that spreads were primarily decreasing due to increased competition in the market. After spreads had reached a more sustainable level given the current levels of competition, the correlation goes up. Even as high as 0.434, although this is still considered to be a moderate level of correlation. Interestingly, the results for the analysis after 2019-01-01 also shows a biweekly pattern, where correlation moves up every two weeks. This could be due to the periodicity of pricing committee meetings for the different market participants. For the period after 2019-01-01, we have therefore investigated the intervals of rate changes for all active mortgage labels in the market. The results of this analysis are shown in Figure 6.

By far most mortgage lenders reassess their pricing on a weekly basis. However, a significant part either does not change rates some weeks, or only changes rates once every two weeks. A very small part change rates less often than once every two weeks. Even though we do see that changes in swap rates can be reflected in mortgage rates changes 4 weeks after. It therefore seems that mortgage lenders rather make incremental rate changes to compensate swap rate changes instead of making big rate changes in one go. The reason for that can be that mortgage lenders do not want to price themselves out of the market as this will cost them market share.

Imbalance of assets and liabilities

Consequently, this market dynamic also causes valuations to lag, as market values are typically calculated based on primary market rates. This can be a disadvantage for investors whose liabilities are valued using liquid market rates. Insurers are (partially) compensated for this using the volatility adjustment [2]. Due to the high volatility in interest rates over the past months, we have observed an increased interest in more frequent and timely valuations that can be used for the calculation of the volatility adjustment. For investors who do not make use of the volatility adjustment, this article has hopefully provided insight into the dynamics of the market that cause this effect and into the length of the lag.

References

[1] Hypotheekbond, LoanClear analysis 2022

[2] Volatility adjustment under the loop, Deloitte, February 2018

Disclaimer

Please read our full disclaimer here.