U.S. mortgage bonds backed by government agencies Fannie Mae, Freddie Mac and Ginnie Mae have so far handily navigated the waters without the recent support of the Federal Reserve, but it may not be smooth sailing for long.

Low volatility in U.S. Treasury yields helped make the Fed's 15-month $1.25 trillion mortgage bond buying spree successful in its goal of supporting the prices of mortgage-backed securities (MBS) of the U.S. government controlled housing finance agencies and kept home mortgage rates historically low.

But the $5 trillion agency MBS market and home mortgage rates are highly sensitive to jumps in long-term Treasury yields.

And if U.S. Treasury yields begin moving in less predictable ways, much of the agency MBS market's stability could evaporate, making home loans more expensive and harder to get.

U.S. TREASURY YIELDS RISING

U.S. Treasury yields jumped roughly 20 basis points following a series of poorly attended auctions at the end of March.

The benchmark 10-year Treasury note, which had been trading at a yield ranging from 3.72 percent to 3.82 percent for several weeks, touched a nine-month high of around 4.0 percent in early April, as worries grew that investor demand for U.S. debt had slackened. The notes are currently trading around 3.82 percent.

The Merrill Lynch MOVE index, which measures volatility in the U.S. Treasury market, has moved higher in recent weeks but only after falling steadily since June 2009. It is currently well below the peaks seen during the financial crisis in 2008 and 2009, and is trading at levels seen in the fall of 2007.

And the 30-year fixed-rate mortgage leaped to an eight-month high of 5.21 percent in the week ended April 8, according to Freddie Mac.

When mortgage rates rise sharply, homeowners are less likely to try to pay off their existing mortgages early by refinancing, a trend that may have already begun.

And the U.S. Mortgage Bankers Association's seasonally adjusted index of refinancing applications plunged 16.9 percent in the week ended April 2, dragging activity down a whopping 67.0 percent below its year-ago level.

EXTENSION RISK

With the U.S. Treasury market sensitive to any sign that the Federal Reserve might raise short term interest rates as the economy improves, mortgage rates will become more susceptible to sharp spikes, heightening a phenomenon called extension risk in the agency MBS market.

For agency MBS investors, the cash flow depends on prepayments of principal made by the homeowners in the pool of mortgages that serve as collateral for the security. Extension risk is the risk that these prepayments will slow down when mortgage interest rates rise.

When refinancing halts, extension risk typically rises and agency MBS investors are left holding onto lower-yielding securities for longer than they had anticipated, missing out on the opportunity to invest in higher-yielding securities elsewhere.

Extension risk is extremely palpable right now in the agency MBS market, said Paul Norris, senior portfolio manager at Dwight Asset Management in Burlington, Vermont.

Another dramatic sell-off in Treasuries could cause some serious damage, he said.

MORE VOLATILITY FEARED

Low interest rate volatility, or a measured and gradual move lower or higher in rates, is the ideal scenario for agency MBS.

Between 4 percent and 4.10 percent (on 10-year Treasury yields) is a very sensitive place. Once we get out of the current range, the selling should shift more to the agency MBS side and we could see a big move, Norris said.

Some analysts believe other triggers lie waiting to cause an even bigger spike in yields. Particularly strong U.S. economic data point or a surprisingly weak U.S. Treasury debt auction could set off another jump.

A sudden spike in yields is definitely possible, said Nicholas Brophy, managing director, head of rates trading for the Americas at Citigroup in New York, noting the 25 basis-point sell-off in 10-year swap rates on Monday and Tuesday last week.

Mukul Chhabra, vice president in the mortgage strategy group at Credit Suisse in New York, said there is potential for further servicer selling in a continued back up in 10-year Treasury yields up to 4.15 percent.

The sector is most vulnerable at 10-year Treasury yields between 4.00 percent and 4.15 percent as duration shedding is likely to be concentrated in agency MBS in this range, Chhabra said.

While private investors were expected to fill much of the massive void the Federal Reserve left behind when it stopped buying agency MBS at the end of March, some are positioning for extension risk, avoiding longer duration 30-year bonds.

Didi Weinblatt, vice president of taxable fixed income portfolios at USAA Investment Management Company in San Antonio, Texas, said she has been front-running extension risk by buying lower yielding 15-year agency MBS.

It is best to play it safe in this environment as few expected the recent sharp sell-off and another one could be right around the corner, she said.

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