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For mortgage masters, 2013 is a bond-picker's market

By Katya Wachtel

NEW YORK (Reuters) - For hedge funds that specialize in mortgage bond investing last year was almost too easy when it came to making money. But this year, mortgage debt traders are cautioning investors to temper their expectations.

Brazilian investment bank BTG Pactual told investors it was closing its top performing distressed mortgage hedge fund to new investors in January because of diminished opportunities in the market.

The $261 million fund, which invests primarily in bonds backed by distressed, private-label, residential mortgages, was one of the best performing hedge funds in 2012, rising 46 percent. But in a recent letter, BTG told investors "not to expect a repeat of 2012's performance."

Private-label mortgages are not guaranteed by government-sponsored entities such as Fannie Mae or Freddie Mac .

For many mortgage hedge funds it will be hard to beat 2012, when the average fund in the group was up 20 percent. By comparison, the average return last year for all hedge funds in the $2 trillion industry was 6.2 percent.

Investors in mortgage funds said they were expecting average returns to fall in the lower double-digits range this year. In a bid for performance some managers are looking beyond plain vanilla mortgage securities into more idiosyncratic fixed income trades, which carry more risk and therefore potentially better payoffs.

If the housing markets takes a turn for the worse, these securities could start to fall sharply as the underlying mortgages weaken.

Mortgage funds benefited mightily from last year's search for yield as the Federal Reserve's efforts to keep interest rates low pushed up the prices for mortgage securities. Bonds backed by subprime mortgages performed especially well, as those beaten down securities rose in value as a recovery in U.S. housing prices began to take hold.

The trade was so lucrative that even hedge funds that don't specialize solely in mortgage trading like Dan Loeb's Third Point and John Burbank's Passport Capital made money on it.

Colin Teichholtz, a senior portfolio manager at roughly $13 billion Pine River Capital Management, who focuses on the mortgage and fixed income markets, said last year an investor who bought the average mortgage bond made money "because everything went up."

He said that will not be the case this year and investors will need to be much more selective because mortgage bond prices have risen so fast and trades are less obvious.

Pine River's Liquid Mortgage Fund gained about 29 percent last year.

There already are signs the gap between mortgage funds and other hedge funds is narrowing. In the first two months of the year, mortgage-focused funds gained 3.36 percent compared to a 2.6 percent for the broader hedge fund universe.

Yields on non-agency mortgage debt have come down since last summer when the Fed announced it would begin buying $45 billion in government guaranteed mortgage debt a month. Then, private label mortgage bonds sported yields between 5.0 percent and 6.5 percent. Yields fall when the price of a bond rises, which has been happening in recent months.

Still, when compared to 10-year U.S. Treasuries, which are yielding 1.99 percent, private label mortgage bonds not backed by a government guarantee look enticing today. Those securities are yielding anywhere from 3.6 percent to 4.75 percent, according to a February report from Markit.

Vincent Fiorillo, a portfolio manager and senior trader in DoubleLine Capital's mortgage group, said this is "not the best year to start learning" how to trade mortgage debt.

He said the shrinking supply of private label mortgage bonds, securities cobbled together from mortgages that are not guaranteed by government-backed housing finance companies, has helped to push prices higher.

The dollar volume of private-label mortgage debt, also called non-agency mortgage bonds, peaked at $2.2 trillion in July 2007, according to data compiled by CoreLogic and DoubleLine.

Issuance of private-label mortgage bonds came to a halt in 2008 with the collapse of the U.S. housing market. Now they represent only 2 percent of new issuance.

Today, the market has shrunk to $909 million in outstanding debt due to a combination of prepayments on mortgages as consumers pay off debt and liquidations of defaulted loans through foreclosure and short sales.

Now, more than four years since the peak of the financial crisis, analysts see several signs of a rebirth in the non-agency securitization market, including news that several banks are looking at putting together mortgage-backed securities deals.

WHERE TO FIND YIELD?

The slimmer pickings in the market are pushing mortgage traders at Pine River and other hedge funds to target other securities to boost returns, such as mortgage interest-only securities (IOs). These securities are cobbled together from the interest payments on mortgage bonds and tend to perform best when refinancings of the underlying home loans is at a minimum, something that normally happens when mortgage rates rise.

Deepak Narula, whose mortgage-focused hedge fund Metacapital Management recorded gains of 41.25 percent last year, is also eyeing certain mortgage IOs in 2013, according to a recent investor letter.

Traders view mortgage IOs as way to prepare for the end or a slowdown in the Fed's bond-buying stimulus policy.

Different IO pools offer vastly different return profiles depending on several factors, including how sensitive they are to prepayments and interest rate fluctuations, said mortgage specialists. Traders and fixed income analysts said betting on these securities is not for amateurs because returns can be impacted mightily if rates declines and mortgage refinancings rise.

"Agency IOs are generating a lot of hedge fund interest. They will do very well if interest rates increase and hence prepayments slow," Laurie Goodman, a senior Managing Director at Amherst Securities said in an emailed comment. "The tone in the market is decidedly more bearish."

Mortgage traders are also pivoting to bonds backed by commercial real estate loans, which they say offers favorable returns for a cheaper price than much of the private-label residential mortgage debt.

But as with residential bonds, investors in commercial mortgage debt need to be highly selective, according to researchers at Amherst Securities.

(Reporting By Katya Wachtel; Edited by Matthew Goldstein and Leslie Gevirtz)

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