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Is Your Bond Fund Partying Like It's 1993?

Mortgage derivatives are back. The question is whether they are better.

Eric Jacobson, 03/25/2010

If bonds and 1993 don't mean anything to you, think of what happened when the music finally stopped: Orange County, derivatives, and bankruptcy. Or perhaps you will recall Piper Jaffray's ill-fated government fund that had advertised itself as safe from Uncle Sam.

Wall Street was naturally behind the scenes of the carnage, slicing and dicing plain-vanilla mortgage pools into exotic mortgage derivatives and selling them at tidy profits. A scant few investors understood them--or their risks--and the damage soured a whole generation on the very word "derivatives."

They're Baaack ...
But while the most complex mortgage derivatives have largely been verboten in the halls of mutual fund companies since then, some have made a comeback, particularly after the 2008 crisis. A combination of rock-bottom short-term interest rates and unusually low levels of mortgage refinancing has been the perfect setting for so-called interest-only and inverse interest-only mortgage securities.

There are different ways to structure IOs and inverse-IOs, and depending on their traits and market conditions, both can be lucrative--but volatile. Inverse-IOs, for example, are designed with inherent leverage in their structures and are extremely sensitive both to changes in short-term rates (usually LIBOR) and shifts in the speed at which homeowners are prepaying their mortgages. When things are going just right, as they were for most of the past year, those securities can pay extremely generous yields and generate massive total returns, even if the market simply remains stable.

Prepayments can be an especially nasty problem, though, because a mortgage that is refinanced (or bought out by government agencies targeting delinquent loans) essentially eliminates some of the principal upon which an IO or inverse-IO security's interest payments are made. The net effect is a permanent loss. And inverse-IOs court an additional set of risks, given that their payments fall if short-term interest rates rise.

Both securities usually trade at very low dollar prices relative to the total amount of mortgage market exposure they provide, and they became even cheaper thanks to the financial crisis. During a recent conversation, for example, Fidelity manager Bill Irving noted that, broadly speaking, the inverse-IO market was priced such that roughly $12 in market value represented $100 in exposure to the mortgage market. Put another way, the market values of inverse-IOs are highly leveraged to even modest price shifts in the mortgage market, so a small change in the aforementioned $100 exposure could represent a big change to the $12 of an investor's market value.

When Fannie Mae and Freddie Mac both announced in early 2010 that they would be buying out delinquent loans (of 120 days or more) from mortgage pools that each has guaranteed, the market reacted strongly to the news, given that the action would be indistinguishable from a rise in prepayments to most investors. According to Mitch Flack of Metropolitan West Asset Management and TCW, that translated to price losses of roughly 10% to 20% for most inverse-IO securities.

Are Dangers Lurking?
What does that mean for your bond fund? Unfortunately, it's difficult to generalize too much, because it's possible that a manager holding these structures may be hedging his risks with other tools or may have even scraped together a handful of ones that, for one reason or another, have become inherently less risky than they once were.

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