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IOs – an alternative play on mortgages

Which floor has the door to US homes?

With the short ABX trade over and done with, Connecticut-based hedge fund Structured Portfolio Management has looked to other areas of the real estate market for investment opportunities. In March, the firm launched the Directional Mortgage Prepayment Strategy fund, which invests in various types of interest-only mortgage backed securities. The fund is designed to take bets on the levels of prepayments on mortgages. In a falling interest rate environment, mortgages tend to witness high prepayment rates as owners take advantage of cheaper refinancing. Conversely in a rising rate market, prepayments on mortgages slow down. "But what happens to prepayments when rates are lower but so are housing prices? What happens to prepayments when rates are lower but lenders are constrained by balance sheet issues from lending?" says Don Brownstein, SPM’s CEO and CIO.

Hedge funds have increasingly been looking at IOs as a means of expressing their views on the housing market and economy in the US. It’s not a strategy suited to everyone, however, says Brownstein, as a deep understanding of prepayment behaviour is needed.

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