Duration risk returns, making Agency MBS more sensitive to rising rates

Overview

This report discusses the return of duration risk in the mortgage and structured products markets. As the 10-year U.S. Treasury yield recently rose to a local high of about 4.69%, concerns about negative convexity and duration extension in MBS have resurfaced. The report also covers CES RMBS and Aircraft ABS, and argues that although spreads on some assets have narrowed, fundamentals, collateral quality, and relative valuation still support selective allocation.

Core views

The key views are: first, Agency MBS sensitivity to rate volatility has increased, and if yields continue to rise or primary/secondary mortgage spreads normalize, duration extension and convexity-related selling pressure could worsen; second, high-coupon MBS face greater extension risk, so portfolios should shift toward slightly discounted coupons such as FN 5.0s and raise hedging ratios; third, CES AAA remains more attractive than non-QM AAA because it has more favorable convexity, improving borrower quality, and more resilient default performance; fourth, Aircraft ABS offers diversification and spread advantages relative to subprime auto ABS, especially for A tranches and possibly B tranches, supported by strong aviation demand and an imbalance between aircraft supply and demand.

Analysis framework

The report follows the threads of rates, convexity, duration, flows, and cross-asset relative spreads, combining evidence such as MBS index convexity, active hedgers' duration changes, primary/secondary mortgage spreads, overseas demand for Agency MBS, CES borrower quality and prepayment behavior, and Aircraft ABS payment resilience during the pandemic to form relative-value judgments.

Methodology notes

• Fixed income riskNegative convexity and duration extension analysis

  When rates rise, MBS prepayment expectations fall, security duration extends, and investors may need to sell or add interest-rate hedges.

  The report measures changes in active hedgers' duration exposure in 10-year Treasury equivalents and evaluates the additional extension risk under a 25 bp rate-up scenario.

• Relative valueCross-asset spread and collateral-quality comparison

  Compare spreads, fundamentals, and downside risk across different structured products at similar rating or risk tiers.

  The report compares CES AAA with non-QM AAA and Aircraft ABS with subprime auto ABS, and assesses relative attractiveness based on borrower quality, default rates, prepayment, payment capacity, and industry demand.

• Flow riskFixed income fund flow threshold observation

  Rate levels and the pace of increases may trigger fixed income fund redemptions, forcing managers to sell liquid Agency MBS.

  The report notes that if the 10-year U.S. Treasury yield breaks above the local high of 4.8%-5.0%, fixed income fund outflow pressure could emerge and underperformance in MBS could widen.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Agency MBS

  Cautious selective allocation

  Strengths

  Fixed income funds still saw healthy inflows recently, overseas investors were net buyers in Q1, and some slightly discounted coupons may benefit if rates ease.

  Weaknesses

  A higher share of high-coupon loans has brought back negative convexity and extension risk, and MBS spreads are now more sensitive to rate changes.

  Comparison

  FN 5.0s are preferred over FN 6.0s-6.5s; although high-coupon bonds are only slightly tighter than in March, extension risk is higher.

  Risks

  Further increases in the 10-year U.S. Treasury yield, normalization of primary/secondary spreads, fixed income fund outflows, and convexity-hedging selling pressure.

• CES AAA

  Preferred relative to non-QM AAA

  Strengths

  More favorable convexity, improving borrower quality, lower CLTV, higher FICO, a higher share of full-doc loans, and default rates below pre-GFC levels.

  Weaknesses

  Spreads have already tightened recently, and the latest AAA deals even priced slightly tighter than non-QM AAA, reducing the margin of safety.

  Comparison

  The report prefers CES AAA over non-QM AAA because it offers better spread compensation and lower delinquency performance across rate scenarios.

  Risks

  Home price declines, deteriorating refinancing conditions, changes in prepayment behavior, and a worsening credit cycle in second-lien mortgages.

• Aircraft ABS

  Overweight versus subprime auto ABS

  Strengths

  Spreads are relatively wider, providing diversification from low-income consumer credit risk; aircraft supply-demand imbalances and strong travel demand support aircraft values; Class A and most Class B tranches showed strong payment resilience during the pandemic.

  Weaknesses

  The sector was affected by COVID-19, the Ukraine conflict, and tensions in the Middle East; payment ability for lower-rated Class C tranches deteriorated materially during the pandemic and has not fully recovered.

  Comparison

  Relative to subprime auto ABS, Aircraft ABS benefits from stronger asset-value support and different risk drivers; the report recommends overweighting the A tranche.

  Risks

  A decline in air travel demand, higher fuel prices, airline defaults, weaker aircraft disposal liquidity, and rating downgrades.

Key data

• MBS rate correlationAbove 70%The correlation between recent changes in MBS spreads and changes in 10-year U.S. Treasury yields has risen to a high level.
• Duration extension among active hedgers over the past three weeksAbout $40 billion in 10-year Treasury equivalentsEstimated period since 2026-04-27.
• Potential duration extension from another 25 bp riseAbout $20 billion to $25 billion in 10-year Treasury equivalentsScenario estimate for active hedgers' MBS exposure.
• 10-year Treasury local high4.69%The report says the 10-year U.S. Treasury yield recently rose to this intraday local high.
• Fixed income fund outflow risk threshold10-year Treasury yield above 4.8%-5.0%Historical experience suggests that breaking above local highs could trigger outflows.
• Primary/secondary mortgage spread low95bpBelow the 2026 April average of 104bp and the 2025 average of 110bp; if normalized, mortgage rates could rise by about 10bp.
• Overseas Agency MBS net buying in Q1$25 billionDespite a $1.4 billion reduction in March holdings, overseas investors were still net buyers in Q1 2026.
• Mainland China institutional Agency MBS holdings changeIncrease of $2 billionThe report says foreign official institutions increased holdings slightly for a second consecutive month.
• Japan Agency MBS holdings changeDecrease of $7 billionBut weekly data from Japan's Ministry of Finance suggest demand may have recently recovered.
• Rocket Mortgage CES AAA pricingTreasuries +115 bpRecent CES AAA issuance priced slightly tighter than non-QM AAA.
• Post-GFC CES prepayment speed10 CPR lower on average, 20 CPR lower at the peakRecent vintages have prepaid more slowly than pre-GFC CES loans.
• Aircraft ABS outstanding balanceAbout 86% of the historical peakBalances have recovered since mid-2024.

Impact & implications

For portfolios, the main risk in Agency MBS has shifted from simple spread valuation to a combination of rising rates, duration extension, and flow pressure. If yields keep rising, high-coupon MBS may come under pressure; if yields retreat because of easing geopolitical tensions or similar factors, lower-coupon paper or longer-duration assets such as FN 5.0s could benefit relatively. CES and Aircraft ABS offer relative-value opportunities within structured products, but investors still need to monitor consumer credit, aviation demand, fuel prices, and macro rate shocks.

Risks

• The 10-year U.S. Treasury yield rises further and breaks above the 4.8%-5.0% range, triggering fixed income fund outflows.
• Primary/secondary mortgage spreads normalize from low levels, pushing mortgage rates higher and exacerbating MBS extension risk.
• High-coupon Agency MBS underperform because of convexity hedging and duration-extension-related selling pressure.
• Geopolitical tensions in the Middle East, inflation, or growth factors keep rates elevated.
• If CES collateral is hurt by home price declines or refinancing pressure, delinquency and prepayment assumptions could worsen.
• Aircraft ABS faces systemic shocks to the aviation industry, higher fuel prices, and lower aircraft residual values.

What to watch

• Whether the 10-year U.S. Treasury yield breaks above the 4.8%-5.0% local high.
• Whether the rolling correlation between MBS spreads and 10-year U.S. Treasury yield changes stays elevated.
• Duration-hedging behavior from active hedgers, GSEs, and other MBS investors.
• Whether primary/secondary mortgage spreads move back toward the 2025 average of 110bp from around 95bp.
• Weekly inflows and outflows in mutual funds and ETFs.
• OAS valuation and effective duration changes in FN 5.0s, FN 6.0s, and FN 6.5s.
• Changes in Agency MBS holdings by overseas investors, especially Japan, Mainland China, Taiwan, Singapore, and Hong Kong.
• Whether pricing between newly issued CES AAA and non-QM AAA continues to invert.
• Aircraft ABS issuance balances, aircraft orders, air travel demand, and fuel prices.