NEW YORK, Nov 20 (Reuters) - Deepak Narula, one of the hedge fund industry's best known mortgage bond traders, said he sees a much tougher year ahead for investors but sees opportunities in certain mortgage trades.
Next year will "be a more challenging year" than 2013 because of "much greater uncertainty around how the Fed will behave," and because of lofty bond and equity valuations, Narula, the founder of $1.45 billion hedge fund Metacapital Management, said on Wednesday.
"When valuations are high, risk is much greater," he told the Reuters Global Investment Outlook Summit. "Throw in changes to the Fed and the Fed's large footprint in the financial markets, which has to change," and there is much greater potential for volatility.
"Bonds outright, I'd be even more scared about than equities," Narula said. When bond yields rise meaningfully, there will be hefty losses for longer-dated credit, he said. Even though policymakers will communicate their intentions "loud and clear," the market in aggregate will see losses
But Narula believes investors from hedge funds to pension funds have a better appreciation of the risk in their portfolios since markets went into a tailspin in the second quarter.
This year Narula's main fund has struggled to produce gains, though an investor recently told Reuters the portfolio has been able to reduce losses in the last few months. However, the firm's $240 million Rising Rates fund, launched in May, has climbed about 14 percent year-to-date.
Last year, Metacapital's flagship fund soared more than 40 percent, as structured credit funds rose about 19 percent on averaged. "Absent some large shock to the system" that causes initial cheapening of assets "those returns are history," Narula said.
Those funds have only risen about 8 percent on average this year.
Managers who invested in residential mortgage-backed securities throughout 2012 and the beginning of 2013 benefited mightily from the Federal Reserve's efforts to keep interest rates low, which pushed up the prices of mortgage bonds.
But Narula called the stimulus measures a double-edged sword. Some of the fund's trades "were hurt by QE," he said. Narula invests in securities with pre-payment risk, which suffer losses when refinancings rise.
His favorite trade going into 2014 is mortgage derivatives. "All else the same, mortgage rates have to go up," he said. "The securities that benefit from that are these mortgage derivatives."
The fund is also bullish on commercial mortgage-backed securities. It "offers better value than residential" MBS, Narula said. His fund has focused on legacy CMBS, issued in 2008 and earlier, adding that there are interesting opportunities in different parts of the capital structure on the long and short side.
Hedge fund managers can go long a security, betting its value will rise, or go short a security, believing its value will fall.
Metacapital looked at risk-sharing bonds recently issued by Fannie Mae and Freddie Mac, which for the first time in many years passed on some of the mortgage default risk to private investors, but did not participate in the offers because "they were priced too tight."
"The compensation for the amount of risk was not adequate," Narula said, adding that as supply increases spreads will widen to more sensible levels and MetaCapital may then step in.
"There's so little securitization of non-government guaranteed mortgages people have been grabbing 1/2those deals) at levels where it makes little sense" to buy.
Before launching his hedge fund, Narula was a managing director and head of two mortgage-backed securities trading desks at Lehman Brothers, which he joined in 1989.
Last year he purchased singer Madonna's 6,000-square-foot co-operative apartment on Central Park West, The Wall Street Journal reported. Asked by Reuters how it felt to be living in the famous singer's former residence, Narula laughed.
"It's still being renovated," he said.
(Reporting by Katya Wachtel; additional reporting by Jonathan Stempel and Luciana Lopez; Editing by Leslie Adler)