Hedge Fund Managers Protecting MBS Profits

Hedge fund managers that invest in mortgage bonds are beginning to wonder if now is the time to lock in early-year gains.

Although the shops generally plan to continue trading throughout the year, many are thinking about easing back on their purchases and taking profits. That’s due to growing nervousness that a recent rise in prices among home-loan securities won’t continue.

The concerns stem in part from wariness among managers that they’ll repeat their 2011 showings, especially with a still-unstable economic outlook. Last year started on a similar note, with a run-up in bond values initially boosting fund returns. But many of the vehicles wound up losing money for the year as their portfolios were slammed in the third quarter by the European debt crisis and S&P’s downgrade of the U.S. “Some are fearful of it going that way. That if Europe heats up again or some other disaster happens . . . all of a sudden we’ll be in a world of hurt. People are absolutely taking less risk at the present time,” one manager said.

Take Galton Capital, where a team led by Kevin Finnerty and Matt Whalen runs nearly $1 billion through three funds and a number of separate accounts focused on mortgage securities. Those vehicles, some bearing the name of Galton backer Mariner Investment, showed year-to-date gains of 3.3-3.5% at the end of February. Now, Galton looks like an early mover in lightening its inventory.

The firm wrote in a letter to backers this month that as mortgage-bond values rose in February, “the heavy volumes helped to establish more opportunities to trade out of positions that have rallied substantially since late last year. Our bias during the month was to take advantage of strong demand by selling into strength, while using supply to reposition into what we believe are more attractive assets.”

Other gainers in January and February included:

CQS, whose CQS ABS Fund was up 2%.

Halcyon Asset Management’s Halcyon Offshore Asset-Backed Value Fund, up 3%.

King Street Capital’s King Street Capital Fund, up 3%.

LibreMax Capital, whose LibreMax Partners was up 4.2%.

Marathon Asset Management’s Marathon Securitized Credit Fund, up 6.7%.

MKP Capital’s MKP Credit Fund, up 2.3%.

Perella Weinberg Partners’ Asset Based Value portfolio, up 1.6%.

Pine River Capital’s Pine River Fixed Income Fund, up 8.5%.

Prosiris Capital, whose Investcorp Prosiris Opportunities Fund was up 8%.

York Capital’s York Credit Opportunities Fund, up 6.7%.

For the most part, the managers expect to record further gains for March, even as some pulled back from the market. Scio Capital’s Scio Fund 1, for example, was posting a year-to-date gain of 6.7% as of March 26 via investments in devalued mortgage bonds, asset-backed securities and collateralized debt obligations.

The timing of the moves reflects a sentiment that there’s only so far mortgage-bond prices can rise. In a March 25 report, Bank of America securitization-research chief Chris Flanagan wrote that the days of easy profits for buyers may be over for now. “At this point given the run-up, despite our improved expectations for the housing market, we feel that most of the sectors are at or near fair value,” he wrote. “Prices in most sectors have retraced all the widening realized in the fall and, in some cases, are approaching last year’s highs seen in February.”

As the year progresses, industry participants will be keeping an eye on some of the same issues that drove market conditions in 2011. “If central banks keep printing money nonstop, it should be a great year for credit,” one manager said. “If they put on the brakes and sovereign debt or other economic concerns return, it might be a bit of a bumpy ride.”

As for backers of mortgage-bond funds, research shop Brighton House said in a report last week that capital is beginning to flow away from the vehicles and into riskier pools as the Europe crisis recedes. However, an investor-relations staffer at a fund-management outfit insisted he’s still seeing plenty of demand from clients — noting that the strategy has shifted over time to seeking yields on junior paper instead of chasing bargains on senior securities in a distressed market.

Others support that view, pointing out that capital inflows have been strong this year.

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