After lightening up their mortgage portfolios in April and May due to rising interest rates and choppy liquidity, portfolio managers at Delaware Management Company Inc. believe that last week's Fed announcement may provide the impetus needed to re-enter the mortgage market with all guns blazing.
"This [announcement] could be good for mortgages and help spread product over the short term," said Stephen R. Cianci, vice president and portfolio manager of the Philadelphia-based investment company. "The surprise was that they didn't maintain the tightening bias, and instead they were neutral. So what I'm looking for now is a good entry point back into the market - and now we might be coming close to one."
More specifically, Cianci is looking for mortgage bond spreads that are "north of 150" on the current coupon mortgage, a goal that might be just around the corner following the Fed's stance of neutrality, he said.
By using the strategy of sector rotation and security selection, the company operates by overweighting spread sectors and underweighting non-spread sectors. Therefore, Cianci considers his department to be more of a "spread shop," rather than a team that focuses primarily on durations and interest rates.
With this method, Delaware Management maintains a fairly sizable portfolio. Out of $45 billion in total assets, the company maintains around $20 billion in fixed-income (including domestic and international), $3 billion of which is in investment-grade bonds. Between 30% and 40% of that $3 billion (or between $900 million to $1.2 billion) is in mortgage-related assets.
Currently positioned primarily in bonds with coupons of 6.5% and 7%, Delaware Management is now overweighted in 30-year paper and underweighted in 15-year paper.
"Our portfolio has recently been slightly underweighted in mortgages relative to the Lehman Aggregate Index," Cianci said. "But then again, we were overweighted up until the end of April and early May, so now we're really contemplating getting back into the market."
Three-Pronged Approach
Cianci considers his company's investment strategy to be unique. The basic idea is that his team tries to maximize the amount of yield it can purchase in the mortgage market while minimizing the amount of option cost. According to Cianci, this is accomplished in a number of ways.
"One of the easiest ways is to take advantage of the roll market," Cianci said. "But rolls have been kind of on the thin side, so it hasn't been the best way to do it."
Another option has been to take advantage of low-loan-balance collateral which has prepayed much slower, especially throughout the rally of January 1999 to April 1999.
"It's weird to say recent rally', since the market just backed up 100 basis points, but it was indeed a rally up until about a month ago," Cianci noted. "But this method kicks off a lot more carry in our portfolio than if we were [buying] just TBA 7's or TBA 7.5's alone."
One type of collateral-specific situation that the company has liked is what Cianci calls the "Alt-A story". With this type of product, prepayments are less sensitive to rate moves, so it provides a nice vehicle for the company, Cianci notes.
Additionally, liquidity concerns in the market have also directed the firm's mortgage team to concentrate on collateral.
"You want to be in the most liquid things in the mortgage market, namely collateral," Cianci added. "With liquidity so choppy, you look for your opportunities in the dislocation in the structured market, which I do think will arise."
Therefore, a third strategy that has become increasingly popular at Delaware Management is to get involved in structured products, such as very plain-vanilla planned authorization class paper.
According to Cianci, Delaware recently bought five-year PAC paper which was "written in very nicely" to its portfolio.
"When we feel there is a relative value opportunity, we'll look at PACs relative to CMBS, relative to corporates, relative to ABS," Cianci said, "and at times PAC paper will look a little cheaper."
The company also invests in CMBS, mainly because it offers a "very good yield" and the current spread-widening in the sector certainly presents an investment opportunity. However, Cianci believes that all spread product, particularly CMBS, will continue to "go through a blip" because of the amount of supply that is going to come from the corporate market. This, Cianci says, could hurt spread product in the short term.
Overall, the company invests primarily in pass-throughs; according to Cianci, the portfolio is approximately 75% pass-throughs and 25% structured product.
"And that is very different than what it was in 1997," Cianci mentioned, "when it was probably 50/50."
Models, Shmodels!
Despite the current buzz in the market surrounding the new technologically-advanced prepayment "supermodels" surfacing from the likes of Bear, Stearns & Co., Cianci believes that other tools for measuring risk in the mortgage market are more impressive.
"I think that prepayment models are important," Cianci said. "But one consistent thing about them is that they are consistently wrong."
Instead, Cianci is far more enthralled by PaineWebber's empirical duration studies for quantifying risk and use of horizon analysis. He is also taken with Goldman, Sachs & Co.'s use of empirical option-adjusted spreads (OAS) and shifting OAS as rates change.
"They are the more unique, cutting-edge things going on in the mortgage market, as opposed to tweaking an OAS model with loan-level data," Cianci said. - AT
