This year mortgages have done very well courtesy of the substantial buying from the Federal Reserve.

Year-to-date gross issuance has totaled $1.5 trillion with net issuance at just under $500 billion. The Fed has bought $1.0 trillion through last week while the Treasury Department has taken a $112 billion share.

When 2009 started, MBS spreads to the current coupon were +127/10-year swaps and +165/10-year notes/ As of yesterday's close, spreads stood at +69/10-year swaps and +78/10-year Treasurys. Spreads got as tight as +51 and +65, respectively, in the latter part of May.

The technical and fundamental landscape is beginning to shift as the Fed slows its buying pace with the program scheduled to end at the end of the first quarter when it will hold $1.25 trillion.

Spreads are expected to widen into yearend and in the first quarter, as the private sector will demand more yield and a more competitive investment relative to other investment alternatives.

Barclays Capital analysts believe that MBS spreads will widen 30 basis points to 40 basis points because of the Fed's exit, while their counterparts at Credit Suisse expect spreads to eventually widen to 115 basis points over 10-year Treasurys.

In addition to the removal of a large buyer from the sector, the market is looking at higher interest rates based on a combination of heavy Treasury issuance and the gradual removal of the government's stimulus programs.

At this time, the 10-year note is expected to average 4.03% by 4Q10 based on the latest economic outlooks from Fannie Mae, Freddie Mac, the Mortgage Bankers Association and the National Association of Realtors with a range of 3.8% to 4.4%. For the final quarter of 2009, the note is projected to average 3.4%.

Meanwhile, 30-year fixed mortgage rates are predicted to average 5.1% in 4Q09 and 5.8% in 4Q10.

Given this outlook and the Fed exit, investors need to start planning now. Barclays Capital recommended considering callable MBS. It is a defensive investment in a rising rate environment, plus it allows investors to lock in the profits made this year, reinvest in a lower dollar price and thus reduce the interest rate risk of their portfolios.

In a primer, the analysts stated that callable MBS are created under the Ginnie Mae callable trust shelf with the official moniker of Guaranteed Callable Passthrough Securities. They pointed out that buying a callable MBS is equivalent to buying a passthrough and selling a call option on it to boost the current yield, but without the hassles of derivative accounting.

The bond generates better base case returns, analysts said, as dollar prices are lower than pass-throughs. It also provides better protection in a sell-off.

In an example comparing a callable MBS to a G2SF 4.5 passthrough, in a 50 basis point increase in mortgage rates over six months, the passthrough loses 48 basis points, while the callable provides a positive return of 52 basis points. Barclays analysts also said that callable MBS look attractive to agency callables.

There are a couple of obvious negatives to callable MBS, analysts acknowledged. One is if rates rally sharply, the callable will underperform the passthrough, but should outperform callable agencies. Second is that callable MBS is less liquid than collateral.

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