Thomas O'Connor, portfolio manager at the Montgomery group of Wells Capital Management, says he is considering shifting 10-15%, or approximately $57-86 million of the firm's $575 million short-term fund, out of mortgage-backed securities into agencies. A trigger for the move would be if the Federal Reserve eases to counter the economic slowdown or if Treasuries rally under a war with Iraq, he says. In those cases, lower interest rates would create a high pick-up in prepayments, leading mortgage products to underperform Treasuries, he says. He declined to define a level at which interest rates would be low enough to trigger such move. Another reason for the rotation is that the firm is overweight in mortgage products and has no allocation to agencies.
So far, O'Connor has been able to manage negative convexity because he has only bought mortgage products that have prepayment protection. The criteria have been to only buy seasoned CMOs, as they have higher refinancing costs, or MBS backed by lower loan balances, he says. Yet, under a dramatic rise in refinancings, such risk may pose a challenge to manage, he says.
O'Connor would sell Fannie Mae or Freddie Mac 30-year 6.5% or 7% higher coupon pass-throughs, as they carry the highest prepayment risk. He would buy agency debentures in the three-year range to pick additional yield.
O'Connor, who is based in Walnut Creek, Calif., used to manage fixed income for Montgomery Asset Management, which was acquired by Wells Fargo & Co. last November. He allocates 50% to CMOs, 25% to MBS and 25% to Treasuries. The fund is neutral the 1.60-year Lehman Brothers one- to three-year government index.
