Investors strategize for Fed's exit from MBS market

By Julie Haviv and Daniel Bases

NEW YORK, Nov 16 (Reuters) - Investors who reaped robust gains in U.S. mortgage-backed securities by piggy-backing on the Federal Reserve's $1.25 trillion buying program are bracing for the end to the central bank's support -- and positioning themselves for a new round of profits as prices cheapen.

The $5 trillion market for bonds backed by the housing finance companies Fannie Mae, Freddie Mac and Ginnie Mae is in for a shock when the Fed stops buying at the end of the 2010 first quarter.

To keep market volatility from stripping away gains, investors have either cut their holdings in the bonds the Fed has been buying most, avoided that part of the market altogether, or resorted to hedging their positions.

Fed buying, just over $1 trillion so far, has not only played a key role in bringing down mortgage rates and kick-starting the hard-hit housing market, but also boosted returns at some of the world's largest bond funds.

As the program winds down investors are preparing for greater volatility. Many are forecasting the sector could cheapen anywhere from 20 to 35 basis points versus Treasuries, which would pare some of sector's significant gains.

Indeed, agency MBS have tightened by about 73 basis points against Treasuries this year.

A much sharper cheapening of prices, however, may be warranted to boost enough buying to fill the Fed's big shoes.

"Based on current market conditions, I believe that U.S. agency MBS current coupon spreads would need to widen anywhere from 50 to 70 basis points relative to U.S. Treasuries in order to fill the demand currently provided by the Fed," said Joe Ramos, lead portfolio manager on the U.S. fixed income team at Lazard Asset Management in New York.

The Fed's purchases of one-sixth of all MBS backed by Fannie Mae, Freddie Mac and Ginnie Mae has recently been focused on coupons yielding 4.50 percent through 5.50 percent.

Martin Sass, chairman and chief executive officer of New York-based MD SASS, said his firm has circumvented those securities, calling them "the most vulnerable."

"We are buying the more seasoned, older mortgage-backed pools. They tend to be less efficiently priced and they are not the ones the Fed is buying," he said.

In addition, Sass, whose firm holds roughly $2 billion in MBS and has been in the market since 1977, said he and others are keeping "dry powder" for an expected fall in prices, although he does not expect an overly dramatic drop.

He expects yields to remain supported by Fed buying of MBS through the end of the program after which spreads could potentially widen 30-35 basis points.

Deutsche Bank's Bill Chepolis, a senior portfolio manager at its retail asset management unit DWS Investments, said in the last quarter his firm sold agency MBS.

If the Fed keeps interest rates stable Chepolis said he would hold more benchmark U.S. Treasuries in anticipation of a weaker agency MBS market.

"We can also sell call options in forward months to make a bet that prices will be lower then," he said. "Another strategy people employ, ourselves included, is to buy interest-only MBS. These have negative durations, so go up in price as rates and MBS rates rise."

Negative duration bonds, as opposed to a typical bond, go up in price when rates go up and down in price when rates go down.

Another popular move has been the so-called "up-in-coupon" trade which entails selling lower yielding coupons in exchange for higher yielding issues. This has occurred largely because U.S. interest rates have dropped sharply as investors have sought a safe haven during the economic crisis.

At the end of the third quarter, Pacific Investment Management Co, the world's biggest fixed income fund manager, known as Pimco, highlighted its reduced exposure to mortgages over the course of this year in anticipation of the Fed's program running its course.

"Pimco plans to maintain a flat to underweight position in mortgages as Fed purchases have driven agency MBS to their near richest levels ever. We look to reenter the market when valuations are more compelling," the firm said.

WHO FILLS THE VOID?

According to results of JPMorgan's October investor survey covering over 160 investors and over $2 trillion in mortgage assets, over half polled are now underweight mortgages, up from a mere 20 percent in July.

"At current market levels we see no investors filling the void," said Lazard's Ramos.

Ramos said until the decline in financial institutions subsides, the biggest holder of agency MBS away from the Fed will be retirement fixed income allocations that are benchmarked against U.S. aggregate indexes such as Barclays Aggregate Index.

Barclays reported on Nov. 12 that according to Federal Reserve data, the top 50 banks shed $34 billion worth residential MBS in the third quarter.

"Interestingly, this decline was driven primarily by a select group of banks including Wells Fargo and Bank of America. Excluding these banks, the remaining top 48 banks increased their MBS holdings by $9 billion," Barclays said.

At the end of September the top 50 banks held $964 billion in MBS, Barclays said.

"This is not like the market goes away when the Fed stops buying," said Jay Diamond, managing director of Annaly Capital Management in New York.

"There might be some repricing but people chase yield and they'll find this at some point," he said. (Editing by Leslie Adler)