While remaining cautiously bearish about the possibility of inflation and keeping a vigilant eye on near-term risks in the mortgage arena, investors at Conn.-based Hartford Investment Management Co. (HIMCO) are taking advantage of a market in which everything currently seems to look cheap.
"When you talk in terms of value nowadays, we believe that it is important to stay more liquid," said Peter P. Perrotti, senior vice president at HIMCO. "We will tend to keep pass-throughs over collateralized surrogates and collateralized mortgage obligations.
"The CMO market simply does not interest us."
With the bulk of the company's paper positioned in 30-year bonds with 7% and 7.5% coupons, HIMCO's team believes strongly that cheap securities remain liquid, especially when there is a lack of appetite in the secondary market.
Out of a total of $55 billion in total assets, HIMCO maintains approximately $7.2 billion in mortgage securities, Perrotti said. The company also invests about $4 million to $5 million in equity.
"We also like whole loans, because we see them cheapening as well. We seek anything that has a better carry profile and limited risk," added Perrotti.
Watching Swap Spreads
Out of all the factors that they take into consideration, the HIMCO mortgage-backed securities department keeps a keen eye on swap spreads.
"The recent uncertainty in swap spreads makes us very cautious at this time," Perrotti said. "It is my belief, however, that things are bound to calm down after the summer. Still, lack of interest in the market has made it extremely illiquid."
Watching swap spreads in order to predict dislocations in the market has been "like a game," Perrotti noted. The company's modified "top-down" approach to selecting investments consists of an opportunistic method of sector allocation.
"Every trade has interest rate bias, but we really only play the interest rate game when we think about adding value in the long term," he said. "Whether we are talking about 7.5% paper or 6% paper, we spend more time betting on where spreads are going."
While industry pundits are predicting a definite lack of supply in the fourth quarter due to Y2K fears, Perrotti's overall take on the subject is that there will probably not be any "major Y2K events" affecting the mortgage market.
"Sure, there will be extra corporate issuance in the third quarter, but the risk is lower in the institutional world," said Perrotti. "I think, in general, investors are well positioned for Y2K."
Analyzing Prepayments
Perrotti considers prepayment models to be "absolutely crucial" to his department's work, and is especially concerned with analyzing each individual model to find its weaknesses.
"You must ask yourself, Where is this prepayment model biased?,'" Perrotti said. "You have to stress [the model], and change certain characteristics in order to adjust to each specific model. For instance, how sensitive is the model to slowing housing turnover? These types of questions must be analyzed to use a model correctly."
HIMCO investors are seeing premium speeds slowing down, and "discount [speeds] remaining at a good clip."
"It is amazing how little burnout helps you in a rally," said Perrotti, commenting on the positive outlook for rates of housing turnover.
"Right now, the housing turnover component is very strong," he added.
Still, Perrotti noted that many investors ignore option-adjusted spread durations during their analyses, and were therefore taken aback last spring when there was a back-up in mortgages and spreads tightened in.
"So, when it stopped tightening, people had to readjust their outlook. There was a lot of compression recently, especially with 6's and 6.5's," Perrotti added.
