Though portfolio managers at Saddle Brook, N.J.-based investment company Lexington Management had been out of the mortgage game since the summer of 1998, this past June seemed to present a golden opportunity for the company to put its money back to work.

"Starting in mid-June, we've been steadily buying, mostly project loans in the Ginnie Mae market," said Denis Jamison, senior vice president at Lexington. "There are some of the best spreads now that we've seen in a couple of years, despite the fact that everyone's durations are a little bit longer. I'm sure some people lost a lot of money this past quarter, but we're at a point where valuations, I think, are pretty good."

Because of the bearish overtones of the second quarter, therefore, Lexington, which is normally a premium buyer, recently moved down in coupon to 6.5% and 7% paper.

But it paid off, Jamison says, because the company is currently getting paid a good spread over the Treasury curve - "with an accent on getting some lockout."

"People slipped down to discount [coupons] this past quarter and extended out," Jamison noted. "Prepayment speeds slowed up, and the cuspy coupons got hammered. We didn't make any money. But compared to a year ago, we've had a good-size correction in the market.

"And now we are gradually picking up pieces here and there, trying to keep the cash flow invested."

Oh, Ginnie, You're So Fine

One needs only to look at Lexington's largest account to get a hint of what its favorite mortgage instrument is.

The company's $350 million Lexington Ginnie Mae Income Mutual Fund constitutes the biggest mortgage-backed securities chunk of its $900 million in total fixed assets, which itself is part of $2.75 billion total assets in Lexington's shop.

"We do have MBS on our other accounts as well, and there, the accent is on the subordinated pieces, either the double-A or single-A tranches of Alt-A or jumbo collateral, or the non-accelerating sequential (NAS) bonds," Jamison said. "But we're very much a buyer of positive convexity in most cases, so we haven't done much in regard to the NAS bonds or the high-grade subordinates lately."

In fact, Jamison is quick to point out that the goal of shrinking his portfolio's negative convexity can be considered an important part of the company's overall strategy.

Although durations shot up recently, the portfolio's negative convexity has shrunken dramatically: since the start of the year, the negative convexity has fallen from 1.6 to 0.9, Jamison said.

"I do like to manage the convexity far more than I like to manage the duration," he said. "If you control the negative convexity in your mortgage portfolio, then you've got a good chance of letting that extra yield income flow through to your total return.

"The lower you can get your convexity, the better you look in total return."

Lexington mainly accomplishes its task of minimizing negative convexity with its project loans. The Lexington Ginnie Mae fund, which is comprised of 15% Treasurys and 85% Ginnie Maes, puts a huge emphasis on project loans - nearly 60% of the Ginnies in the fund, which Jamison considers to be a large position.

Additionally, the company has dabbled in 10-year Treasury inflation-protected securities, or TIP, bonds, which currently make up about 15% of the portfolio.

"We've done some analysis of TIP bonds versus nominal coupons," Jamison said. "The Street has a convention with TIPs that they have half the duration of the nominal coupon, but if you analyze doesn't correlate well at all with interest rates, at least not at this point."

Jamison thought that TIP bonds would be a nice addition to Lexington's portfolio, especially since it appeared that inflation was going to pick up amid the second-quarter bear market atmosphere.

"TIPs did not correlate very well with interest rates, so it looked like a good safe place to put our money."

Sector Rotation, I Think Not

When it comes to discussing strategy, Jamison eschews the widely held notion that sector analysis is the most effective route for investors to take.

"Any time you work with really high-grade securities, the name of the game is interest-rate anticipation," Jamison said. "It would be nice to make believe it was something else, but sector spreads are basically closely tied to interest rate trends. It is not something that stands on its own.

"Sector analysis, I believe, does not really work that well."

According to Jamison, investors in the bond market can be split up into two categories: those that are interested in credit and those that are into interest rates. Though his group certainly fits into the latter category, he admits that interest rate watching can sometimes be a risky gamble.

"You've got to control your risk, and realize that you don't want to move out too far on the curve. You want to keep your portfolio in balance," Jamison noted.

Overall, however, interest rate anticipation is no more risky than pretending that one is trading sectors, Jamison says. But in order to cut down on risk even further, Lexington's investment team tends not to trade collateral very often, and especially not structured product.

In anticipation of Y2K, Lexington is keeping some extra cash handy. Approximately one month before the end of the year, the company is going to take the interest paydowns and principal paydowns - and then refrain from investing it.

"People will want to liquidate and you don't want to be out there selling on December 31," Jamison said.

"Right now our cashbook is very low - maybe a half percent cash position - but we would let that build up to three to five percent, as Y2K approaches." - AT

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