Mortgage-backed securities looking good in 2014: Pro

Why Narula likes mortgage derivatives

Both commercial and residential mortgage-backed securities will be great investments in 2014 as the Fed starts tapering and long-term interest rates rise, says a top hedge fund manager.

Deepak Narula, founder and head of top-performing hedge fund Metacapital Management, says his firm is betting commercial mortgage-backed securities will be top performers in 2014, he told CNBC's "Halftime Report" on Monday.

"If you look at CMBS spreads, they are a lot higher than what you can get in the high-yield market, they are a lot higher than what you can get in the residential mortgage-backed securities markets," he said. "And so it is a sector that we think will do better—but in more credit-risky securities, not necessarily the AAA securities."

As for what will happen once the Fed does start tapering, "it's anybody's guess," Narula said.

(Read more: Here's what could push Treasury yields to 2% in 2014

Budget for increased volatility: Pro

"The Fed buys net $40 billion in agency mortgage-backed securities every month," he said. "That's $500 billion a year. And they are going to stop doing that at some point. So it is reasonable to expect that spreads in the high-grade sector will widen."

Once that happens, the yields will go up at the long end of the yield curve yields, and volatility will pick up, he said.

Many expect Fed Chair nominee Janet Yellen to continue the dovish approach the Fed has taken since the financial crisis. "When that is your baseline forecast, there is volatility to the extent that there are deviations from that," Narula said. "So it's a year where I think you should budget from a pickup in increased volatility".

(Read more: US oil, gas juggernaut on course through 2016: EIA)

QE3's aggressive expansion of the Fed's balance sheet has landed it in "uncharted waters," Narula said.

"We have an economy that is a lot better, whether you look at housing, you look at equities, employment, on every metric we are in a lot better shape than we were" in 2010, he said. "The only reason yields are at these levels is because of where inflation is."

—By Robert Ferris, Special to