Explain extension risk — why does my MBS get worse when rates rise?

Question

AcadiFi · Accepted Answer

Extension risk is the second half of MBS negative convexity. When rates rise, borrowers stop refinancing, but they also delay moving (the 'lock-in effect') and home turnover slows. Scheduled cash flows stretch out, so the investor is stuck holding a below-market coupon for longer than expected.

Example: Theron Okafor buys a 4% pass-through in 2025 assuming 175 PSA and a 6.5-year WAL. Rates spike 200 bps in 2026. Prepayments collapse to 70 PSA. The WAL extends to 10.3 years. He now owns a 4% bond in a 6% world for four extra years — exactly the wrong duration profile.

Quantitatively, extension raises effective duration at the worst possible moment, amplifying mark-to-market losses. Empirical durations on 30-year agency current-coupon TBAs routinely swing from 3 to 7 years as rates whipsaw.

Risk managers address extension through:

- Hedging with payer swaptions (pay-fixed options that gain value when rates rise).
- Buying CMO PAC tranches with wide collars that resist extension.
- Structural selection: shorter reset ARMs, hybrid 5/1 loans.

Remember: contraction and extension are mirror images of the same embedded short call. The MBS investor is short a prepayment option to the borrower, so they lose at both tails. OAS quantifies that option cost in basis points.

Explain extension risk — why does my MBS get worse when rates rise?

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