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The pony people (aka Wells Fargo) has just issued a mortgage-backed securities alert.
(Bloomberg) — Extension risk in mortgages is “far more severe” than production coupon models suggest, Wells Fargo managing director on the mortgage trading desk Kevin Jackson wrote in a client note.
Investors need to ask themselves how they feel “about current compensation for extension risk”
Interest rates moving higher make it “far more difficult” to model and assess turnover, first time borrower demand and trade up/trade down propensity
Convexity/gamma “adds an additional layer of pain to extension” as higher levels of implied interest rate vol suggests higher levels of extension
Recommend adding new origination and select seasoned cash flows as defense against implied interest rate vol
Yes, 30-year mortgage rates are rising, and rising faster than the benchmark 10-year Treasury yield.
Extension risk occurs when securities with call or prepayment options (like MBS) delay their expected call dates or prepayment speeds and effectively extend the expected maturity or duration. And rising interest rates (like today) leads to rising duration and convexity on MBS.
The Wells Fargo wagon is delivering higher MBS duration and convexity. Hedge accordingly!