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, while the Fed has bought $1.04 trillion through Nov. 25 and the Treasury has taken a $112 billion share through October.

When 2009 started, MBS spreads to the current coupon were 127 basis points over 10-year swaps and 165 basis points over 10-year notes and, as of Dec. 1 close, stood at 65 basis points over 10-year swaps and 76 basis points over 10-year Treasurys. Spreads got as tight as 51 over and 65 over, respectively, in the latter part of May.

The technical and fundamental landscape is beginning to shift as the Fed slows its pace of buying, 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 year end 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 have previously stated that they expect MBS spreads will widen 30 to 40 basis points because of the Fed's exit from the market. Meanwhile, Credit Suisse analysts 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 as a result of 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 the outlook and the Fed exit, analysts are encouraging investors to start planning now. Barclays Capital analysts 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 issued in November, they stated that callable MBS are created under the Ginnie Mae callable trust shelf with the official moniker of Guaranteed Callable Passthrough Securities. They said 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, said analysts, as dollar prices are lower than passthroughs and provide better protection in a sell-off.

They acknowledge that there are a couple of "obvious" negatives to callable MBS, including that if rates rally sharply, the callable will underperform the passthrough (but should outperform callable agencies). Another is that callable MBS are less liquid than collateral.

While technicals are favorable for the near term, fundamentals will start taking over. Valuations are very rich at this time with prices near all-time highs.

FTN Financial MBS analysts said their best advice is "not to try to perfectly time the uncoiling of the spring with a quick basis trade."

They think that while investors should stay invested in the RMBS space, they should look for areas that will shield the portfolio from the constantly shifting market sentiment and Fed action that looms.

Specifically, they think investors should gradually diversify away from the most liquid proxies in the MBS sector "to mitigate basis risk without sacrificing needed carry."

In their report, they looked at a 2005 30-year 6% pool as an example and compared it with a two-year corporate, a 1.75-year agency bullet and callable.

They noted that the specified pool is well insulated to a high degree from MBS basis widening. They also added that libor option adjusted spread levels on the pool have to widen out 20 basis points and more before it underperforms the alternatives.

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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