The 10-year Treasury yield rose by 2% this week, its highest level since the Federal Reserve announced the continuation of an open-ended third round of quantitative easing on Sept. 13

As a result, various market analysts believe the upward trend of 10-year Treasury yields will continue even though the Fed will maintain its bond purchasing plan, noted agency mortgage-backed securitization strategy analysts Sarah Hu and Ashley Gam of the Royal Bank of Scotland (RBS)

With a rise in interest rates, the mortgage market has become "increasingly concerned with extension risk," the RBS analysts said.

Click on the graph to view the timeframe of the 10-year Treasury yield.

The analysts estimated the change in 10-year Treasury equivalents of the agency mortgage-backed securitization market under different rate scenarios. Given that the Fed does not hedge its book, the scenarios for the MBS realm were adjusted for the Fed’s settled holdings.

The current outstanding balance of fixed-rate agency MBS is $4.37 trillion. After excluding the Fed holdings, the current outstanding balance totaled $3.38 trillion. Thus, the Fed’s settled holdings of $980 billion accounted for 29% of outstanding fixed-rated MBS, the analysts said.

If rates increased by 25 basis points, the duration of the mortgage market is projected to increase by roughly $153 billion in 10-year equivalents. Additionally, a 25 basis point rally is expected to shorten mortgage duration by $114 billion in 10-year equivalents, the report stated.

Therefore, the results show the mortgage market is currently biased towards extension risk.

"While these estimated duration changes could help gauge potential convexity hedging needs for servicers, originators and portfolio managers, actual needs will be much less than suggested by these estimated duration changes. Part of the reason for this is that some servicers are not hedging at all, while others are not actively hedging. Additionally, the Fed, the largest investor in MBS, doesn't hedge its books," the analysts said. 

In a rate sell-off, cuspy coupons — the cusp of the inflection point of the prepay curve versus coupon and bonds — are projected to have the greatest extension exposure as 58% of extension risk comes from 3.5s and 4s coupons. 

Conversely, super premiums – 6s coupons or above – are the safest from a 'convexity point of view,' as Home Affordable Refinance Program refinances could keep their extension risk marginal, the analysts noted.

Click on graph to view MBS duration extension in 10-year equivalents by coupon.