It may surprise European investors to know that the US mortgage market is more than twice as large as the US corporate bond market, which is its closest competitor in terms of income. In size, the agency pass through market (the largest mortgage sector) now exceeds the Treasury note market.

As well as the fixed rate pass throughs, the other major sectors of the market are adjustable rate mortgages (ARMS), tranched pass throughs called collateralized mortgage obligations (CMOs) and commercial mortgage backed securities (MBSs) on properties ranging from offices to basketball stadiums.

Like other fixed income securities, the different sectors of the mortgage market are sensitive in varying degrees to interest rate levels, the changing slope of the yield curve, and interest rate volatility. However, mortgages carry extra risks because changes in interest rates alter the dynamics of mortgage cash flows. Active management is therefore absolutely vital to harvest the high yield, credit quality, and liquidity of the sector without falling victim to its potentially destructive characteristics.

The best way to describe the pitfalls of mortgage investing is to describe how the most basic mortgage security, the pass through, works. A pass through represents a claim to the cash thrown off by a bundle of mortgages (we prefer residential mortgage pass throughs to commercial mortgage ones because they are more liquid and offer better credit quality as well as higher yields). The cash comes from two sources: mortgage borrowers pay interest on their loans, and they also repay the principal on a set schedule. The reason for the name 'pass through' is that after fees are deducted by various agencies, the rest of the cash is passed through to the holder of

the security.

Unfortunately, pass throughs are subject to something called prepayment risk. Borrowers have the right to prepay their mortgages at any time, and tend to do so when interest rates fall, in order to refinance their homes more cheaply. This means that the cash flows thrown off by mortgages are less predictable than those thrown off by a typical bond. Evaluating the probable rate of prepayments for different mortgage backed securities is one key element of analysing these securities.

PIMCO's style of mortgage management is to seek value over a long holding period, and to diversify across many mortgage sectors and strategies. Having the analytical skills and experience in this complex sector is key to assessing relative value, and to managing risk. An obsession, as we have, with refining proprietary analytical models also helps.

In summary, active management is crucial because of the dynamic nature of mortgage assets. Managers must constantly re-analyse the risk characteristics of mortgage products. A final point: managers should at all times maintain a healthy respect for the uncertainties of the mortgage market. Bill Powers