While investors might be tempted to hedge mortgages short in duration, JPMorgan Securities MBS analysts warned that the Federal Reserve might have inadvertently aggravated extension risk.

Fed buying shifted the TBA deliverable to longer WALA buckets: 25-30 for 5.5s. For example, if the market suddenly sells-off, the deliverable will shift to news WALA pools as they become the production coupon — and these "are significantly longer in duration" versus seasoned pools,  analysts said.

In addition to 5.5s having this risk, the story is similar in 5s that would be prone to extension risk sooner, analysts said, as only a 50 basis points sell-off will move them to the production coupon.

JPMorgan's model calculated 2006-2007 vintage 5s at a 2.6-year duration, but new production is around 40% longer at 3.6-years.

The analysts recommend investors underweight the belly of the stack (5s and 5.5s) due to their rich fundamentals. However, they also warn of the risk from extension from changes in the deliverable, "which could ultimately prove to be a catalyst for overall mortgage underperformance in 2010."

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