Mortgage bonds guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE) sold off Wednesday as two key stakeholders in the market - investors and homeowners - weighed the impact of rising interest rates.

The yield on the 10-year Treasury note crossed the 3.5% threshold on Tuesday, which, for many market participants, was the tipping point beyond which they would have to pare down their holdings of these guaranteed mortgage bonds, referred to as agency mortgage debt.

For existing and potential homeowners, meanwhile, the rising Treasury yield raises the specter of mortgage rates once more creeping up beyond current lucrative low levels.

These fears fueled waves of selling in mortgage bonds, with some $10 billion sold Wednesday, according to JPMorgan. The yield on the current coupon widened about 8 basis points to 136 basis points over comparable Treasury yields Wednesday afternoon. It also hurt the Treasury securities market, as investors began hedging their mortgage portfolio by selling Treasurys - driving those yields significantly higher. Mid-afternoon, the yield on the 10-year Treasury note was at 3.68%, a jump of nearly 20 basis points on the day.

The rising yield on the 10-year Treasury note, which is typically used as the base to determine mortgage rates, poses a significant challenge to the government's attempts to keep mortgage rates low.

Mortgage rates currently are at 4.82%, slightly above their record low of 4.78%.

"It's a very challenging problem for the Fed," said Matt Jozoff, head of mortgage research at JPMorgan Chase.

Market participants believe the sell-off may prompt the Fed to boost either its buying of Treasurys, or mortgage bonds, or both.

"The market is pressing the Fed to make some decisions, and buy Treasurys," Jozoff said.

The hope is this would help lower Treasury yields, similar to the effect on mortgage bonds since the central bank started buying those at the start of the year. Risk premiums on mortgage bonds now are about 140 basis points narrower than before the Fed's intervention.

This has caused mortgages to outperform Treasurys by 220 basis points, according to Barclays Capital research.

The Fed is already buying Treasurys to the tune of $300 billion. That's much less than the more than $1 trillion it has committed to the mortgage-related debt markets, prompting some to call on policy makers to shift their spending, rather than commit fresh funds to the Treasury purchase program.

That would help alleviate concerns over the dollar, which has suffered from worries that the Fed's inflated balance sheet will create inflationary pressures in the longer run.

While an unexpected boon for investors, the rising Treasury yields pose an unexpected risk to mortgage-bond portfolios. As interest rates rise in an improving economy, there is little incentive for homeowners to refinance or make more than the required monthly payment.

Some mortgage strategists, such as Walt Schmidt of FTN Financial, suggest that investors are better off betting on 15-year mortgages than 30-year mortgages. There are fewer worries about prepayment, and rates on 15-year mortgages have held stable at 4.5%.

-By Prabha Natarajan, Dow Jones Newswires, 201-938-5071; prabha.natarajan@dowjones.com