SHK Fund Management, a unit of Sun Hung Kai in Hong Kong, is marketing a US mortgage-backed securities fund for the second time. It first introduced the fund last summer as the first (and so far only) product under its alternative investment division, raising $220 million. But the fund's returns failed to meet its targets. Now SHK has brought out the fund's New York-based manager, both to explain and to raise new funds, because this strategy is designed to take advantage of the current difficulties in the US economy.

Although offered to regional investors under the SHK name, the fund is actually managed by Michael Farrell, chairman and CEO of Fixed Income Discount Advisory Co. (Fidac), which is a $28 billion mortgage-backed securities specialist.

Farrell is in the midst of a regional tour to meet investors and talk about the environment in the US right now.

Essentially, the ultra-low interest rate environment was bad for the MBS investor. As the 10-year Treasury bond rate fell as low as 3%, Americans took advantage of this to refinance their homes. This meant they were paying off their previous housing loans early.

An investor like Fidac holds mainly MBS issued by FreddieMae and FannieMae, America's two giant mortgage-backed securities issuers. The paper is rated AAA, so investors don't have to worry about whether they'll get paid back every penny. Rather, the risk is when they get paid. Early prepayment hurts the yield because the interest on the principal diminishes, and it also means that homeowners are switching out of high interest-rate loans into lower ones. So all that refinancing meant Fidac's portfolio wasn't reaping the rewards it expected. Its target return of 350-500 basis points above the 10-year Treasury suffered over the past year and returned only 250-300bp over.

That is now changing, however, because 10-year Treasury rates in the US snapped back in June to 4.5%, and that's dampened refinancing activity. "Going forward we'll be getting higher dividends," Farrell says.

He explains his strategy works best against a steep yield curve. The Bush administration's creation of a record-sized budget deficit has prompted the Federal Reserve to raise 10-year rates in order to allow the US to compete to attract international capital, which helps the MBS investor.

Moreover, continuing low utilization of capacity in the US, the easing of the short-term Feds funds rate to combat rising unemployment, and persistent deflation, combine to enforce that trend. This means that US borrowers will be paying their mortgage loans later than sooner. "It's not good for my country but it's good for my business," Farrell says.

Fidac is adjusting its asset allocation toward a more aggressive stance, which means buying more fixed-rate mortgage-backed securities. The portfolio it runs for SHK, however, is of a defensive nature, meaning no more than 15% can be in fixed-rate MBS. Currently the portfolio has 7% in fixed, so it still has room to move. Currently 93% is invested in mortgages adjusted on a yearly rate, and in monthly floaters that reset off one-month Libor.

Farrell says one difference he's noticed among Asian investors is that they understand the warning signs now surfacing in the United States - because the signs are all too similar to those preceding the Asian financial crisis in 1997. "If in 1997 you knew what was coming, what would you have done?" Farrell says. "Sell property and stocks, and hold bonds and cash."

He sees a similar situation in the US, where the housing market, which has protected America from the worst of the stock market crash, is ready to pop. The Fed has tried to soften the impact by cutting rates to stimulate the housing market, but that tactic has played itself out. The benefits of the Bush tax cuts are one-offs, diluted by the concurrent cuts in state government budgets. The last option for the government is to lower the Fed funds rate (short-term rates) which, combined with rising rates on the 10-year, would make the yield curve steeper - and raise the income for holders of US agency MBS.