RYE, N.Y. -- Market-neutral mortgage-backed securities hedge funds will be a good investment this year, according to a new report.
Following the severe volatility of 1998, the continued wide spreads in the mortgage-backed securities market will offer market-neutral investors an opportunity for making substantial profits with limited downside risk, said the report from Tremont Advisors Inc., Rye, and Ellington Capital Management, Old Greenwich, Conn.
"If someone were to take action now and get in (to these hedge funds) in February or March, it will be an attractive climate for mortgage-backed strategies," said Barry Colvin, director of research for Tremont and a major contributor to the report. "The spreads between Treasury bonds and mortgage-backed securities are still wide by historical standards."
The small number of buyers in the market -- a number of fixed-income arbitrage trading organizations have either left the business or dramatically scaled back operations -- should keep spreads wide, according to the report.
Rising interest rates also will help keep mortgage prepayments low, as borrowers will have no incentive to refinance, giving mortgage-backed securities another boost.
The report also points out that the credit risk is low because, unlike many other forms of debt, most mortgage-backed securities are AAA rated.
The absence of credit risk in a period of low prepayment uncertainty and wide spreads makes mortgage-backed portfolios excellent vehicles for high risk-adjusted returns, the report says.
"We think spreads now for mortgage-backed securities are wider than they should be," said Mr. Colvin. "The institutions still have what happened in 1998 on their minds. "Whether it's justified or not is another matter. That's part of our argument (for investing now)."
Hedge funds best bet
Market-neutral mortgage-backed securities investing is most common among hedge funds and is the best way to capture the returns in this market, according to the report.
Unlike long-only or directional trading strategies, market-neutral managers attempt to capture the spread between a portfolio of mortgage-backed securities and an index, such as Treasuries or LIBOR.
The strategy involves:
* Assembling a portfolio of mortgage securities that have substantial spreads in excess of the target index. This can be done by purchasing mortgage-backed securities or mortgage-backed securities derivatives and assembling a portfolio of positions, which, in the aggregate, resembles a bond.
* Hedging the portfolio to reduce its exposure to a variety of risks, including changes in interest rates, the shape of the yield curve, interest rate volatility and convexity.
* Establishing a short position in either LIBOR or Treasuries, or a combination of the two, to serve as the spread-capture mechanism.
* Creating a hedge, wherever possible, to deal with changes in the spread differential between mortgages and the hedge due to fundamental factors that cause shocks to fixed-income markets such as rises in interest rates, defaults by a major borrowers or changes in investors' perceptions of credit quality, all of which could induce them to seek the safety of Treasury securities.
These hedge funds capture spreads between mortgages and other indexes. They also establish positions that counter the effects of changes in mortgage prepayment rates, interest rates and other factors on their portfolios.
They are among the few "hedge funds" that genuinely are hedged against known risks, according to the report.
It also states that once a manager assembles and hedges a valuable mortgage-backed securities portfolio, the performance it generates can last for up to two years. Therefore, investors who buy into existing funds obtain portfolios with wide spreads and longevity.
"Fortunately, it doesn't take but a temporary widening of spreads to create a consistent portfolio that will have good returns for up to two years," said Mr. Colvin.
For the risk-averse
In a period when interest rates are more likely to rise than fall, and when interest rate volatility is likely to remain high, market-neutral hedge fund strategies are an appropriate way for risk-averse investors to participate in the mortgage-backed securities marketplace, the report says.
The report's recommendations for choosing a hedge fund are:
* It should use leverage of no more than three to one -- for every dollar of invested capital, the firm owns no more than three dollars of mortgage-backed securities.
* The portfolio should be broadly diversified, holding numerous positions across a variety of mortgage sectors and mortgage-backed securities types.
* It should use dynamic and out-of-the-money strategies to minimize risk.
* The fund should be managed by experienced mortgage-backed securities traders and conduct proprietary research to create its own risk-management models.
* It should use independent, third-party valuations of its positions and allow investors to see the prices or value of their positions upon request.
Following these steps should result in strong returns, Mr. Colvin said, "provided that there isn't some incredible, exogenous shock," to the mortgage-backed securities market during the year.
