Look for mortgage collateralized bond obligations to get a little spicier in the next year as a tight fixed-income market is making fund managers grow more creative.

Mortgage CBO volume for 1999 was slightly over $5 billion, marking a small increase from 1998's volume. The issuance volume remains an impressive leap from the roughly $50 million years of the mid-1990s, but the slight stagnation indicates the sector has not been immune from the travails of the broader capital markets.

While mortgages have outperformed the London Interbank Offered Rate by 160 basis points over the past five years, that spread has inverted since summer 1999. That means fund managers are contending with declining net asset values, and some newcomers into the market are taking evasive action.

For example, Newbury Funding, a recently launched CBO, attracted market interest because it featured a heavy investment in BBB-rated mortgage securities, a sector of the market that most mortgage CBOs in the past have avoided.

Almost all of the collateral for mortgage CBOs to date has been U.S. Treasurys, agency securities and AAA-rated MBS and ABS. As of December 31, 1999, such bonds made up 96% of the collateral of all existing mortgage CBO portfolios, with the mere remainder going to AA and A-rated bonds.

This is because mortgage CBO managers have been trying to leverage their ability to manage duration and convexity risk, and thus choosing very safe market sectors to extract relative value, Fitch IBCA analysts said. But as the Newbury Funding CBO indicates, a different strategy, emphasizing riskier bonds, may be growing.

"Investment managers have been expressing a desire to move toward lower and below investment-grade securities to enhance yield," said Richard Hrvatin, senior director at Fitch.

Newbury, whose investment advisor is Colonial Advisory Services, has a roughly 30% BBB bucket for its portfolio, which consists of $540 million in commercial paper and $187 million in notes. At least 70% of its portfolio will be invested in A-rated investments or higher with a minimum of 30% invested in AAA' investments, and no security purchased may have a rating below BBB-minus.

Analysts expect more new CBOs to follow in Newbury's footsteps. About one new CBO is expected to come per month for 2000, or about three new deals per quarter.

In a way, riskier mortgage CBOs are simply a return to form for the structure. CBOs started life in the early 1990s primarily backed by high-yield debt and high-yield CBOs have become one of the most dominant forces in the junk market in recent years, having taken over some of the influence yielded by mutual funds, who have deserted the market in droves.

Fitch analysts also expect to see greater usage of the "cash flow" type of analysis among mortgage CBO managers. Such a structure entails achieving credit enhancement via excess spread between high-yielding assets and low cost debt issued by the CBO.

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