FLASH UPDATE: TRV Weekly Commentary - Opportunity in IOs

TRV Weekly Commentary
Week Ending 17 Dec 2014

Comment:

This week was an active week in trading, particularly in commodities, rates and MBS derivatives on market turmoil. Below are some highlights that have contributed to the increase in vol this week:

• WTI crude futures reached an intraday low below $55/barrel on the Tuesday (see graph)
• The Russian ruble depreciated to a high of $79.16 USD from $64.23 USD (see graph)
• The Swiss National Bank imposed a negative 4.6 bps deposit rate on Thursday
• The FOMC meeting minutes reflect a close monitoring of inflation and the “transitory effects of lower energy prices” on Wednesday
• The 10/5 spread compressed 8 bps
• The 10yr reached an overnight low of 2.01 on Tuesday

Implied vol on 10yr swaps increased 3 ticks on these data points and we saw equities, spread and credit products sell-off. The market turmoil largely began due to lower energy prices, causing the Russian Ruble to depreciate substantially. From there, a domino effect insured with the S&P500 selling off 2.64%, the mortgage basis underperforming by 4 to 9 ticks versus 10yr hedges, and IOs cheapening between 10 and 64bps of OAS.

In IOs, we argue that it may be an opportune time to be in the market as the underlying fundamentals are intact and refi risk is contained. A meager drop in mortgage rates and an unchanged refi index support this thesis. We see the best opportunity in 3.5s of ’13 as the IO benchmark widened 64 bps this week. Another potential opportunity lies in RMBS as 60+ delinquencies are generally declining, LTVs have been improving, and dealers have inventory in their balance sheets that can be cleaned up before year-end. We have seen some paper with strong credit support and stable cash flow selling for LM70s that may be sourced cheaply.

As we prepare to launch in the next couple of weeks, we look forward to future market dislocations that will provide opportunities in our markets.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Russian Ruble vs WTI crude futures

Contagion! Is that still a word?

Liquidity in the lower rated junk bonds has already started to become tentative at best.  Over the last few months, volatility has risen significantly and a true reassessment of risk has begun with investors.  Bid-ask has been gappy and inconsistent, both on the downside and upside.   It has been fairly obvious for a long time that investors are not being compensated properly for the risk that they are taking on in the high yield market, particularly in the CCC-rated sector.  As pain from the energy sector spills over into the rest of the high yield market, and illiquidity becomes a reality, investors may soon be met with a reminder about what the word “contagion” means. 

HYG & JNK are trading at 2 year lows, and retail investors who blindly own high yield for the “safety of fixed income” are likely scratching their heads, as they wonder why and how their investment can lose in price.  They probably thought that it was just a safe yield that they could bank on.  30% of high yield ETF holders are hedge funds, and they will move the needle quickly when trying to avoid any losses from a headline risk type of trade, such as being long high yield.  Outflows have not started yet in these two ETFs, but if the past is any indicator, outflows will be large and fast.  July 2014 saw $12.6 B of overall high yield outflows; the impending problem could make July pale in comparison. 

As contagion takes hold, the illiquidity will likely become an exponential problem, as liquid equity ETF structures and daily dealing mutual funds struggle to create underlying bond liquidity, especially at a NAV that doesn’t represent significant gaps.  Once those gaps start to become apparent, trust is quickly lost in the structure itself.  NASDAQ released a white paper earlier this year, citing liquidity as the #1 ETF myth that could lead to investor losses. Lower rated high yield paper is starting to roll over…how will you be positioned? 

Enjoy the football today,

Richard Travia

Director of Research

FLASH UPDATE: TRV Weekly Commentary - Rate & Refi Volatility

TRV Weekly Commentary
Week Ending 19 Nov 2014

Comment:

The 10/5 spread compressed to 71 bps this week as rates bull-flattened. We attribute half of the 6 bps decline to Japan’s poor 3Q GDP print. On an annualized basis, Japan’s economy contracted 1.6%, a stark contrast to expectations, a 2.2% expansion. This data point shocked Japanese equities, with the Nikkei falling 3% . The US bond market reaction was more muted, although implied swaption vol ticked up 2 bps. We do anticipate that the unexpected contraction of the third largest economy will have had a meaningful impact on US output.

Assuming Japan’s recession has a material impact on US growth, we would expect rates to rally and spread products, such as mortgages, to lag. For now, the basis continues to outperform its Tsy hedges as down-in-coupon MBS outperformed the 5yr by 8-10 ticks. We retain a neutral to bearish view on the basis as the yield spread between the current coupon and the 5yr is 1.89 standard deviations below its mean, origination remains strong, and the Fed has finished growing its balance sheet.[1]

Notwithstanding the fall in Treasury and primary mortgage rates, the refi index fell 17 points. While this seems counterintuitive, consider that the average 30-year mortgage rate reached a low of 3.93 only one month ago. Two important mortgage concepts come into play, seasonality and the refi ‘elbow’:

§  Seasonality has a large impact on turnover in the housing market. The housing market, in terms of existing home sales, tends to pick up in the spring, reach its peak in the summer, and decline through the winter as shown in the Prepayment Seasonality chart. When a homeowner sells a house, the existing mortgage principal is paid off in full upfront, just as it happens in the case of a homeowner refinancing his loan. As we enter the winter months, prepayments will likely decrease absent a large movement in rates or a new government program.

§  The refi elbow, on the other hand, refers to the homeowner’s incentive to refi at prevailing rates. If the rate incentive were only 5 bps, we would expect minimal refi activity. However, if the rate incentive increased to 25 bps, we would expect refi activity to pick up. The Refi Elbow chart illustrates the impact of shifting the ‘elbow’ 50 basis points, thus adding 50 basis points to refi incentive. As incentive increases, we see the one-year CPR for a FNMA 3.5 TBA increase. The term ‘elbow’ comes from the shape of the curve, which loosely resembles an elbow.

Considering these concepts, it's no surprise that the refi index fell this week: seasonal impacts likely overcame the minimal shift in rates. We hope this illustration informs the reader of a portion of the anatomy of prepayments.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Prepayment Seasonality

Refi Elbow

Mortgage Basis Data

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[1] We estimate the basis as the difference between the price of Bloomberg’s MTGEFNCL Index and the yield of a generic 5yr Treasury. The data show daily spread levels between 11/21/2007 and 11/19/2014. See the chart at the end of this document for more information.

FLASH UPDATE: TRV Weekly Commentary - Impact of Duration & Convexity

TRV Weekly Commentary
Week Ending 11 Nov 2014

Comment:

Rates continue to rise following last month’s sharp rally leaving the 10yr 2 bps higher at 2.36. We’ve also seen implied volatility on the 1Mx10YR swaption declined to 69 bps. Investors’ comfort with risk assets has led the mortgage basis to continue to tighten to 139 bps –2 bps tight to our regression model, although 2bps is within the standard error of the model. We continue to expect the basis to widen, as the burden of absorbing supply will increasingly be on private investors i.e. non-Fed purchasers.

The minimal rise in rates had a small impact on the refi index as it closed down 31 points to 1590. Although we expect rates to rise in the near future, investors are pricing in higher refis as OAS on benchmark IOs continued to widen. Most notably, premium 4s and 4.5s of 2010 widened the most this week by 11 and 17 bps, respectively. If rates continue to drift upward and volatility remains low, we would expect these coupons to tighten in terms of OAS. A trade to express such a trend would be a premium/discount IOS swap.

Given a rise in rates and decrease in vol, we would expect to see spec pool payups to fall. Our expectations are generally in line with spec pool prices; loan balance decreased across the coupon stack between 1 and 4 ticks while LTV stories decreased in premium 4.5s between 2 and 12 ticks as seen in LTV>105. With rates increasing steadily, we prefer TBA versus spec for the time being.

Noteworthy:

This week, we look at convexity risk on 2010 IO trusts. Given today’s rate, spread and prepayment environment, the entire 2010 IO stack displays negative duration. The benefit to negative duration IOs is that the interest rate exposure can be hedged by purchasing TBAs – a strategy that typically exhibits positive carry. The chart below shows that a sizeable rate movement is required to bring the IOs into positive duration territory. For the time being, we foresee carry remaining positive. While negative duration is beneficial to an IO/TBA carry strategy, IOs are at their lowest point of convexity. In other words, duration is at its most sensitive position with respect to rate movements and hedging costs may increase as rates move.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

IO Duration and Convexity

FLASH UPDATE: When will the Big Fish Hit?

The fisherman carefully baits his line and casts it into the perfect spot.  He patiently waits, because he knows that big fish come by this spot regularly.  He doesn't panic, rather the wait makes him feel a certain sense of inevitability.  His decades of experience remind him that this series of actions almost always results in a big catch.   He is not concerned that no other fishermen know how prolific this hole has been.  He notices his bobber get pulled under briefly, but it pops up again...he remains patient...Again the bobber goes under, but it seems like just a nibble and it comes up to the surface...he remains patient but his anxiety starts to build...The bobber goes under for a third time, but the feel of the line is familiar this time and suddenly the reel starts to empty...FISH ON! 

We are getting multiple opportunities to add to our short high yield positions at asymmetric price levels.  Since July, volatility in the high yield market has picked up considerably, with both positive and negative swings.  This is our bobber...We are still able to short significantly challenged companies at prices above par and at or near the call price.  The opportunity is here and now.  

What is most interesting is that we have seen this many times before:  volatility picks up, sensational headlines start to draw attention, bond prices start to feel shaky and companies start to falter.  Our many years of experience make this feel like a repeated pattern of events.  The outcome is predictable, but the route to get from start to finish often provides exciting new experiences.  It is the exciting new experiences that take most stragglers and tourists out.  The yield-chasers will be burnt.  We know that we will survive those exciting new experiences, but are you prepared?   

Have a nice week,

Richard Travia

Portfolio Manager, Director of Research

FLASH UPDATE: TRV Weekly Commentary - Vol Forthcoming

TRV Weekly Commentary
Week Ending 28 Oct 2014

Comment:

As of week’s end, rates are 20 basis points lower month-over-month, although the route here was anything but gradual. The UST 10-year yield reached an intraday low of 1.87 on October 15th and has since retraced approximately 70 percent of the peak to trough distance. With the Fed officially ending its Treasury purchase program, we begin to see signs of market volatility.

In addition, future market volatility may be exacerbated by decreased dealer liquidity, particularly in spread and credit products. Much has been written on this topic as investors, financial columnists and regulators express concern regarding potential illiquidity in volatile markets. For now, this week’s lull in volatility has been beneficial for spread and credit products: premium TBAs outperformed their Treasury hedges by between 3 and 9 ticks while IOS indices tightened between 30 and 40 basis points of OAS. Despite the “risk on” mentality, we maintain a cautious view as potential headwinds may arise.

Given our viewpoints, we thought we would use this week’s commentary to examine the costs of hedging an IO as we might do in the portfolio. Going long a position in IOS FN-2003 5.5% carries at 1.5 ticks a month. Adding FN 4.5 TBA to hedge the mortgage rate and neutralize duration exposure adds 8 ticks. To offset additional curve risk we might use interest rate swaps and/or US Treasuries, costing 1 tick. And given our view on volatility, we might utilize straddles to hedge gamma and vega, consuming 2 ticks. The net result is 6.5 ticks of carry.[1]

The above illustration shows that hedging activities can have a material impact on strategies that include carry as a source of returns. Some risks may be worth hedging, while others may not be depending on your market views. Of course, the best hedge is to have no position on at all, but the opportunity cost is great.

Happy hedging,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1]  Calculations and table produced using Credit Suisse’s Locus platform

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 21 Oct 2014

Comment:

Following last week’s dramatic risk-off sentiment and increase in volatility, we saw a moderate retracement as the 10yr sold off 9bps and implied volatility decreased 22bps. The basis performed well as investors cautiously added risk. The stack added 5-7 tics versus its 5 and 10yr hedges, as the curve moved in a parallel fashion. Despite the tightening, we remain bearish on the basis as we foresee increased volatility in the coming months. Additionally, we have seen average daily supply increase for three consecutive weeks to $2.7 bln, which is also a concern for the basis.

Primary rates hit 2014’s low on October15^th as the national average 30-year fixed mortgage rate fell below 4% to 3.93. The significant decrease in primary rates led to a 23% increase in the refi index, sparking fear of increased refi activity. Investors especially penalized slight premium benchmark IOs, demanding greater OASs for the perceived risk. FN30.350.10 widened 51 basis points this week, while FN30.400.10 widened 39 basis points. We anticipate spread widening for 3.5 IOs as refi optionality comes into the money on lower rates and increased vol. A 4/3.5 IOS swap may be a trade to watch to capture further spread widening in 3.5s.

Over the last two weeks, we saw spec pool payups on premium 3.5s increase, particularly on medium and low loan balance stories. Notably, payups increased 7+ and 6+ ticks for LLB 3.5s and MLB 3.5s, respectively. Also of note is the increase in the price of prepay protection for CR 4s as payups increased 10 ticks during the same period.[1]

Lastly, the FHFA outlined a plan to refine the Rep and Warranty Framework and provide clarity as to when the GSEs would exercise their remedy to require loan repurchase. The FHFA hopes that the plan will lead to lower perceived risk to originators allowing them to write loans more freely. The announcement caused little market action as it is expected to have a marginal impact.

Noteworthy:

In this week’s noteworthy section, we examine whether the payup on FNMA 4 LLB and MLB prices prepayment risk fairly. To analyze the price of prepayment protection, we used the FNMA 4 November TBA price as of 10/21 to calculate its OAS to swaps. We then priced LLB and MLB FNMA 4s of 2010 using the TBA OAS. We found that actual payups were more than one point cheap according to our prepayment and OAS model. We thus expect payups to increase as refi risk comes to investors’ attention.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1] LLB and MLB collateral describes low loan balance and medium loan balance collateral. These collateral types typically offer prepayment protection as the dollar incentive to refinance is lower with lower mortgage balances.

CR collateral is 30yr collateral composed entirely of mortgages with LTVs greater than 125. High LTV implies prepayment protection due to perceived difficulty to refinance.

FLASH UPDATE: Vulnerable High Yield Bonds Fall in Price Prior to Spike in Defaults

After speaking to many investors over the last year about the opportunity of being short high yield bonds of vulnerable and challenged companies, I think the most common misconception is that there is nothing to do until default rates spike.  Many market prognosticators are calling for significant spikes in the US corporate high yield default rate, starting in 2016 and likely sustaining to 2018-2020.  Does that mean that we should try to time being short closer to 2016?  The answer is unequivocally no…Once default rates start to spike, the short trade is most likely near its end and one should be thinking about buying asymmetrically priced, defaulted or distressed bonds where you have multiples of upside available. 

As an example, during 2007 and 2008 the annual default rate was below 2% every month with the exception of December 2008.  December 2008’s final default rate number didn’t come out until mid-January 2009.  Had you waited for a spike in rates in order to start putting short high yield bond trades on, you would have had about the worst timing possible as markets essentially went on an unabated six year run straight up starting in March 2009. 

With special thanks to Dr. Altman, Brenda Kuehne and the rest of the NYU research team for data, please see the below chart which shows the quarterly default rate, the 12-month moving average default rate and the index of defaulted debt securities.  You can simply see that every period of persistently low default rates is followed by extended periods of negative price performance in the index.  Every period of extraordinarily high spikes in the default rate is immediately followed by strong positive price performance in the index.  Extended periods of low default rates are a LEADING INDICATOR OF SPIKES IN DEFAULT RATES.

We think that the time is now to be short of the most vulnerable and challenged high yield corporate bonds.  Most of these companies have been consistent underperformers over the better part of the last decade, have cyclical or secular headwinds, are in serious danger of default or restructuring and are strangely trading at prices at or above par.  Take advantage of the asymmetry available today and the fact that we have had 15 consecutive quarters of annualized defaults below 2.2%. 

Happy Columbus Day, as Italians we don’t get very many holidays!

Richard Travia

Portfolio Manager, Director of Research

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 07 Oct 2014

Comment:

The yield curve slope was unchanged as both 5 and 10yr yields fell 5 basis points. The 10yr, currently at 2.39, continues its rally from its mid-September peak given reduced global growth projections from the IMF and the Fed. Volatility continues to increase as market participants expect the Fed to end its MBS purchase program this month. Despite an imminent end to Fed tapering, mortgages kept pace in the rally as performance surpassed that of benchmark Treasuries. Discount coupon performance was 2 ticks better than par and premium coupons this week due discounts having higher spread duration.

The refi index closed up 61 points (5%) as 30yr fixed rate mortgages fell 3 basis points to 4.30. We saw refis as a percentage of loan applications rise to 56.4 percent into the rally. OASs on premium and cuspy IO benchmarks (4s of 10-13 and 4.5s of 10 and 11) increased between 2 and 5 basis points on what investors perceived as a slight uptick in prepayment risk. It may be worthwhile to watch for widening in these benchmark bonds if rates continue to rally. Oppositely, benchmark 3.5 IOs of 10-13 tightened between 7 and 8 basis points as investors continue to reach for yield. IIOs had a great run in September, grinding between 50 and 100 basis points tighter given lower supply, slower seasonals, and a low refi index. Although at local tights, a few dealers justify the current IIO clearing levels.

Spec pool payups were relatively flat despite the rally. The lull in price action precedes prepayment day when September factors are released. Generally, September prints generally came in line with expectations while par and premium speeds came in faster than anticipated. Spec pool payups continue to be cheap compared to their theoretical payups when priced to TBA OAS. Using this analysis, 30yr 5s appear the richest, as loan balance and FICO payups are between 60 and 70% of their theoretical prices.

Noteworthy:

Given this week’s lunar eclipse (and ensuing moon selfies), we thought it would be appropriate to share a fun fact about our celestial neighbor. The moon’s orbit has increased from 14,000 miles to 280,000 miles since formation as it steals a fraction of Earth’s rotational energy.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Jeff Kong featured in Opalesque - New Fund Launch

Benedicte Gravrand, Opalesque Geneva:

Tradex Global Advisors is concocting an all-weather absolute return strategy that aims to exploit the inefficiencies within the mortgage-backed securities (MBS) market. It will be run by Jeff Kong, who used to manage Passport Capital’s M1 Fund and SPM’s mortgage fund.

Jeff Kong joined Tradex Global Advisors LLC, an alternative asset management company based in Greenwich, CT, as a partner and portfolio manager responsible for all mortgage-related strategies, in July.

"Looking forward, we certainly expect the fixed income investing landscape to change dramatically as central banks alter course and the rules change. Success in this arena requires a talented and seasoned portfolio manager as well as an equally skilled organization. I believe that with Jeff at the helm, our business has both," then said Michael Beattie, one of the firm's founding partners and its Chief Investment Officer.

Prior to joining Tradex, Mr. Kong was a portfolio manager at Passport Capital, which he joined in 2010 to run the M1 Fund(which returned 13% in 2012). During the previous 10 years, Kong managed the approximately $1bn flagship SPM mortgage fund (the Structured Servicing Holdings or SSH) at Structured Portfolio Management; that fund annualized at +23.6% during his tenure. Prior to that, Mr. Kong served as a director at Donaldson, Lufkin & Jenrette for whom he was a market-maker in mortgage-backed securities, and a vice president at Greenwich Capital Markets.

"I have partnered with Tradex to launch a fund not unlike what I’ve managed in the past, both at SPM and at Passport," he told Opalesque. "Joining forces with Tradex was an easy decision since we have been in business together for over 10 years, as Michael and Richard were early investors in SSH. Our team is currently finalizing documents for our business relationships and service providers, and we are looking to launch the Tradex Relative Value (TRV) fund by Jan 1, 2015."

According to Mr. Kong, TRV is an all-weather absolute return strategy that aims to exploit the inefficiencies within the mortgage-backed securities market.

TRV’ strategy employs the arbitrage of implied versus delivered fundamentals to extract alpha. Because the performance of mortgage-backed securities is dependent on the understanding of the imperfect and changing behavior of borrowers, the team’s experience across numerous market cycles is advantageous, Mr. Kong says. The TRV platform enables them to provide excess returns for their investors throughout various interest rate and economic cycles.

The goal is twofold: to target a high level of positive carry in the fund and to capitalize on market dislocations that frequently present themselves during times of change or stress, as has occurred many times during Mr. Kong’s career.

"In fact," he adds, "the current economic landscape could likely lead to the type of market disruptions and volatility that present significant opportunity to the TRV strategy: the Fed’s exit from quantitative easing, the end of generationally low rates, and the questionable role of the Agencies in housing finance are examples of catalysts to market dislocation. With our infrastructure and team, we are excited to launch TRV into what we see as a period of uncertainly and therefore opportunity."

Background
An MBS is a type of asset-backed security that is secured by a mortgage or collection of mortgages. They are traded actively, much like bonds. The majority of MBSs are issued and backed by government-sponsored corporations such as the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). These securities provide safe income, and some capital appreciation as interest rates fall. Some investment banks, such as JP Morgan Chase, Citigroup and Credit Suisse, andMorgan Stanley, are being sued by investors claiming they were misled on the safety of MBS before the crisis, CalPERSbeing one of the alleged victims. But such securities are back in fashion among asset managers.

The Credit Suisse Fixed Income Arbitrage Hedge Fund index is up 3.89% YTD (to August) and returned 5.77% over the last 12 months. The HFRI Fixed Income-Asset Backed Index is up 7.1% YTD, 11.2% in the last 12 months.

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 30 Sep 2014

Comment:

The yield curve continued to bull flatten as the 10/5 spread fell another 4 bps to 73.3. To put recent flattening into prospective, the 10/5 spread was 122.7 bps exactly one year ago. Given the global economic backdrop, our opinion is that the yield curve could very well flatten into a rate hike cycle. Mortgages’ performance was in line with their 5yr hedges but could not keep pace with the 10yr rally. Implied volatility on the 1Mx10Yr swaption also ticked up 6 bps last week as Bill Gross’s departure from PIMCO gave investors a lot to digest.

The Refi index fell another 4 points to 1294 as refis currently account for 56% of total mortgage applications. We expect this percentage to fall into a rate hike cycle and increased burnout. It is estimated that 36% of the loan universe has both the necessary equity and rate incentive to refinance. As we enter a period of declining refi activity, spec pools may counterintuitively provide extension protection.

Per se, we note that high LTV pools with rate incentives may provide extension protection as HPA increases and home equity builds. There were some sizeable movements in spec pool payups this week, particularly in cuspy loan balance FN 4.0s. HLB 4s, for example, fell 13 ticks this week to 0-10+ over TBA prices while LLB 4s fell 10 ticks to 0-23 over TBAs. We view these valuations as attractive with HLB 4 and LLB 4 payups trading at 21% and 34% of their theoretical payups, respectively. We derive theoretical payups by running the spec cohort at TBA OASs.

Benchmark IO OASs continued to tighten this week, with FN 4.5s of 10 tightening 12 bps and FN 4.5s of 11 tightening 11 bps. In comparison, IO 4s of 10 and 11 tightened only 2 basis points. Despite yield curve flattening and increased volatility, investors continue to price in lower prepayments for high coupon IOs.

Noteworthy:

MBS correlations to CDX IG have spiked to six-month highs. Higher correlations have historically preceded a reversal and we consider this possibility given recent tightening and a decreasing Fed takedown.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Is "Data Dependent" Necessary Language?

"Data dependent" is a term that Janet Yellen probably used ten times in her speech two weeks ago, and one that between Ben Bernanke and herself, has been uttered hundreds of times since the financial crisis.  Easing accommodations will be dependent upon the growth of the economy.  Since the 2008 recession, the economy has recovered slowly but surely.  Observe the following, since March 2009:

- The Industrial Production Index has risen approximately 24% (+4% in the last year)

- The ISM Manufacturing Index has risen by approximately 64% (+4% in the last year)

- New Housing Starts has risen by approximately 95% (+8% in the last year)

- The Case-Shiller Index has risen approximately 20% (+8% in the last year)

- The Unemployment Rate has fallen from approximately 8.7% to 6.1%

- GDP has risen from approximately -0.5% annually to +4.6% annualized (as of Q2)

- The St. Louis Fed Financial Stress Index has fallen approximately 130%

- The Consumer Sentiment Index has risen approximately 40% (+2% in the last year)

You can choose to believe all, some or none of these figures.  That being said, although many or most of these may be unsustainable, if easing accommodations is “data dependent”, What Are They Waiting For!?

Maybe the Fed has no intention of ever returning to a market driven, supply & demand focused economy where the level and length of government intervention is the only important driving factor.  Maybe they are just afraid to find out how the market reacts upon completion of the Taper and true withdrawal of liquidity from the system.  After all, it has been six years of zero-interest rate policy and six years of awash liquidity, where there is no precedent for what comes next. 

I expect that the end of Taper and the eventual withdrawal of liquidity will not go as smoothly as Chairwoman Yellen hopes it will.  Additionally, I think there is a possibility that without outside liquidity and support, the economy will not be quite as “strong” as it has been.  In the last 4-5 years, US HY issuance has been unprecedented, but with the background of the tepid growth environment there are many companies that have deteriorated significantly across many metrics.  We expect that will be exacerbated in a less liquid environment, one in which capital markets will be much more difficult and expensive to access and one in which we think might be on the horizon.

Enjoy your Sunday,

Richard Travia

Director of Research

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 23 Sep 2014

Comment:

Treasuries rallied this week as 10yr yields tumbled to 2.53 from 2.62 on increased geopolitical concerns and strife in the Middle East. The rally came in spite of Thursday’s strong initial jobless claims that came in at 280k vs 305k expectations. Although rates rallied, the yield curve flattened yet another 2 bps, leaving the 10/5 spread at 77 bps. Implied volatility on the 1M X 10yr swaption fell 4 basis points to 61 (a local low) in the event-filled week that contained Fed minutes, Scottish Independence referendum, and airstrikes. In mortgages, the basis held up well vs 5yr hedges with lower coupons providing the greatest return in the rally.

The refi index fell an additional 99 points, further easing refi concerns for cuspy coupons that exhibit high convexity. This week was another active week in Agency IO/IIO ahead of the FOMC meeting as the market saw about $1 BB in BWICs. We saw OAS on premium IOs (4.5s+) tighten between 15 and 20 bps while IO 4.0s and below widened a couple of basis points. Higher coupons continue to be well bid as investors priced in materially lower expected prepayments.

In contrast to TBAs outperforming spec pools in the second week of September into a sell-off, we saw specified pool payups generally increase into the rally. Seasoned 2012, 2013 and 2014 collateral was between flat and up 3 ticks, with 4.5s seeing the most price action. The greatest change in payup we saw was FN 3.5 LLBs decreasing 4 ticks.

Noteworthy:

The MBX 400.10 -50bps swap (vs MBX 350.10) closed at $2-25 this week, leaving the price at the first percentile, or -2.5 standard deviations, from its 2 month mean. The trade offers ¼ of a tick in positive carry on a matched DV01 basis.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 16 Sep 2014

Comment:

The yield curve steepened six basis points Tuesday to Tuesday between 5yr and 10yr maturities to 82 basis points ahead of the FOMC statement on Thursday. Market participants looked to see whether the ‘considerable time’ language remained in the FOMC statement with respect to the federal funds target range. The language indeed remained and the Committee decided continue to reinvest portfolio runoff past a rate hike. In line with the curve steepening, lower duration mortgages performed the best with FNMA 4.5s leading the stack up six ticks vs its 5yr hedge on the week. We continue to remain neutral on the basis as Fed takeout of total issuance is still large, but will inevitably decline. Analysts estimate that Fed reinvestment will result in a 30% takeout of gross issuance by the end of the year, down from 38% of current takeout, adjusting for CMOs.

The refi and purchase indices were relatively flat this week, both ending within a point of last week’s levels. There was a noticeable uptick in BWICs and trading volume in IO and IIO markets, with most selling coming from fast-money in lower coupons. Volatility ticked up this week pre FOMC, helping to push OAS wider. FN IO 4s of 13 led the widening at seven basis points wider. This week’s moderate widening reversed last week’s tightening in benchmark IOs (GNR 2010-26 QS, GNR 2010-20 SE, FNR 13-121 SA, etc.).

Specified pools payups were relatively unchanged this week. Most notably, LLB, MLB, and HLB payups on 4.0s all fell a tick. In terms of OAS, CK 4.5s widened the most (7 bps), while the street anticipates a convergence of speeds hedge ratios for specified 4s relative to TBAs. The carry profile of spec 4s, relative to TBA, should improve on converging speeds.

Noteworthy:

We like up in coupon IOS 4.5s of 2010 versus IOS 3.0s of 2012, matched one-for-one current face. The trade offers 3 ticks of positive carry and is poised to tighten in terms of OAS as investors become more comfortable with low prepayments in up in coupon IOs.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Lack of Dispersion Creates Asymmetry of Short HY Opportunity

Although we are clearly starting to see some dispersion amongst specific credits, it is precisely the lack of dispersion that has created the asymmetry of the short high yield opportunity.  Today, well over 90% of the high yield market is trading over par.  On average, BB’s and B’s are trading approximately at 105 and CCC’s are trading approximately at par.  The spread between Investment Grade and High Yield according to JP Morgan is near 20-year tights at 185 bps versus the 20-year average of 371 bps. 

Generally, in the context of this fully heated credit market, there has not been a true differentiation between single names within a sector or within the entire HY universe.  Post-2008, there of course was an all-out effort to recapitalize and stabilize the US and global economy.  QE (and its derivatives & successors) were the confidence boosters that the economy needed to get going.  Banks were mandated to lend, and eventually succumbed to the pressures to do so.  Capital markets were open for business and, as we have said before, all companies, good and bad, were able to go out and issue debt.  US HY Issuance peaked out in 2007, with $132.7 B of bonds being brought to market.  This dropped to $50.7 B in 2008, but was followed by $127.4 B in 2009, $229.3 B in 2010, $184.6 B in 2011, $280.5 B in 2012, $270 B in 2013, and $153.6 B this year through 8/31.  Obviously issuance has been off the charts, and CCCs as a percent of the total HY issuance has been growing steadily, to what is now 21.5%. 

To illustrate the lack of dispersion, we have shown a summary of financials of four companies that operate in a similarly challenged sector, all with very disparate fundamentals and all trading at or near par:

We think that company fundamentals will very soon start to matter for challenged high yield companies, and we are observing some pockets of dispersion within specific sectors.  Retail shorts have been significant drivers of performance this month, a trend that we think will continue.  Please reach out if you’d like to discuss the opportunity to be short in the high yield space today.  Also, on Wednesday at 11:30AM EST we will be hosting a webinar on the current bubble in high yield credit with Dr. Ed Altman.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global  

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 02 Sep 2014

Comment:

The yield curve steepened 3bps as the 5yr sold off 6 bps Tuesday to Tuesday on stronger ISM numbers. A few dealers speculated that the Sep 2 rates sell-off was a result of a peaceful weekend despite Prime Minister David Cameron raising Britain’s terror threat level to ‘severe’ last Friday. Implied volatility on the 1Mx10 YR swaption increased another 7 bps last week, of which 4 bps increase occurred on Friday.

In mortgages, primary rates reached a local trough at the end of August as we saw the refi index increase 1.4% to the highest level in 12 weeks. Not surprisingly, payups to TBA increased the most (+0-8) for call-protected CR >125 LTV 4.5s this week. On a z-score basis, LLB, MLB, and HLB 3.5s increased more than 3 standard deviations (+0-060 each) over the past 5 days as call protection cost increases. The price of call protection is currently the highest for >105 LTVs and LLBs for 4.5s as refi concerns gain momentum. Projected 1M speeds for these stories are 9.59 and 23.46, respectively.

Benchmark IO OAS continues to widen as FN30.400.13 increased 7bps to 176 bps on higher volatility and lower mortgage rates. FN30.400.11 IOs are trading much richer at 60 bps as seasoning plays a significant factor in pricing. Price multiples for IO 4s of 13 and IO 4s of 11 closed the week at 6.664 and 6.398, respectively. Despite recent widening, we still see valuations at the tighter end of the range with a lot of interest in higher coupon Ginnies.

Noteworthy:

Trace data show that August saw the lowest Agency mortgage derivative volume of the year. Despite the low volume, it was the second highest net customer derivatives buying of the year. The seemingly juxtaposed circumstance points to low customer selling and low new issuance.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Ready, Set, Pop!

When balloons inflate, it is typically a long and slow process and always difficult to tell when they are full.  Towards the end, the balloon stretches and stretches, making room for those last few short breaths.  When you've reached the end though, it just doesn't feel right and you start to think more cautiously.  Of course as we all know, balloons burst.  Once that magical maximum capacity is reached, the balloon POPS in spectacular fashion, exploding with vigor - loudly and violently.  

There are three phases in the trajectory of the current fully-heated high yield market:  1) Overbought conditions, 2) Rate tantrums, and 3) Defaults.

Overbought Conditions

Clearly we have been in "Overbought" territory for quite some time.  According to the BAML Master High Yield Index, the average current high yield bond price is 104.10.  The average new issue clearing yield is 6.28%, down from 7.33% two years ago.  In the last year alone, the CCC new issue clearing yield has fallen from 8.77% to 7.79%.  The average yield-to-maturity is 6.18%, down from 7.35% two years ago.  

Forward calendar volume is already starting to reflect a small amount of hesitation in appetite, coming in at 19% lower than this time last year.  After growing rapidly over the past 10-15 years, high yield now comprises roughly 15% of the overall corporate (investment grade) bond market, which itself is estimated at roughly $9.8 trillion, trailing the U.S. Treasury market ($12.1 trillion outstanding) but larger than the municipal bond market ($3.7 trillion outstanding), according to first-half 2014 estimates by industry trade group Securities Industry and Financial Markets Association (SIFMA).  In 1996, the  high yield market was $200 billion.  

  

As the market has grown and issuance has exploded, Cov-Lite, PIK and PIK-Toggle issuance has had a resurgence, on pace to surpass the most recent highest annual volume in 2008.  PIKs are viewed as more highly speculative debt securities.  Essentially, the company through in-kind payment is creating more debt in a situation where it doesn’t have the capital to service the debt.  This blatant disregard for credit risk among the already obvious reach for yield is clearly setting up the next default cycle.

  

Rate Tantrums

On May 22, 2013, Former Fed Chairman Ben Bernanke announced that the Central Bank would begin scaling back its monthly asset purchase program.  This was followed up with a June 19th press conference, where he optimistically described then-current economic conditions, and reiterated that the taper would commence later in 2013.  In the next 48 hours, the 10Y Treasury yield rose approximately 35 bps, from 2.20% to 2.55%.  The 10Y Treasury yield hit 3% by the end of 2013.    

The value of the USD vs other currencies also rose significantly on the announcement, with some EM FX falling as much as 15-20% vs the USD.  In the four weeks following the May 22nd announcement, high yield ETFs and mutual funds saw $12.3 billion in redemptions.  This alarming outflow was only recently surpassed by outflows in the July-August 2014 technical sell-off ($12.6 billion in outflows).  Given that the Fed makes up approximately 90% of the new-issue MBS purchases, the reaction in the mortgage market was even more violent.  Annaly (NLY), a well-known mortgage REIT, lost 35% of its value from the date of the announcement to the end of 2013.  

  

The stock market continued to show relative strength though, only selling off approximately 5.5% in the month following the original announcement.  These collective reactions caused what is now referred to as "Taper Tantrum".  

The nervousness in the market about a new and improved tantrum is starting to become evident.  Bloomberg reported caution from UBS and other market participants last week.  Larry Hatheway, UBS's Chief Economist said, “The main show is soon to arrive.  With the ‘taper’ nearly complete, there are fundamental and institutional reasons aplenty to fret that last summer’s ‘taper tantrum’ will be find its sequel. Beware ‘rate rage.’”.  The Barron's this weekend is calling for significant forthcoming volatility in the bond market, suggesting that the announcement to raise rates may come as soon as the Fed's September 16th meeting.  As US Treasury yields hit lows due to geopolitical concerns and buying from sovereign debt relative value players, the rise could catch many off-guard, despite pretty much everybody knowing in their heart that it's coming.  

Investors notoriously chase returns.  The St. Louis Fed recently wrote a paper on the dangers of chasing returns (it was focused on equity mutual funds, but the premise holds true), which pointed to a high correlation of flows to past returns, of course resulting in inflows at exactly the wrong time.  Despite the recent ETF & mutual fund outflow hiccup in high yield, overall growth of the market has been unprecedented since 2010.  Some ETF operators have even caught on to the fear of rising rates, putting together what the Barron's expects could be a recipe for disaster - Long High Yield ETFs hedged with Short Treasuries.  (Although I agree that interest rates will rise over time, perhaps significantly, in the fickle world of trigger-finger happy retail investors, at the first sign of a risk-off environment these products could lose on both sides of the trade.  Investors thought all they were doing was protecting their coupon, when in reality they were ignoring credit quality again.)  

Defaults

Dr. Ed Altman, a world renowned expert on corporate bankruptcy, is an advisor to our short-biased high yield fund, and has conducted in depth research on the current credit bubble.  The current benign credit cycle, which has been near or below 2% for the last five years, is expected to considerably increase over the next three to five years.  Without taking the currently fully heated credit environment into account, it is clear that high yield default rates are incredibly cyclical.  The average annual default rate since 1971 is 3.14%, with below average default cycles lasting three to four years typically, and above average default cycles lasting one to two years.  Any sustained period of extraordinarily low defaults has typically been followed by a significant spike in default rates.  

The corporate high yield sector has been refinancing and increasing their debt significantly and consistently since the current benign credit cycle started in 2010.  New high yield issuance topped $200 billion for the first time ever in 2010.  2011 new high yield issuance was just below $200 billion, and 2012, 2013 and 2014 (the pace through the 1st half) have all topped $200 billion since.

Issuance is unprecedented, and the quality of that issuance is clearly suspect, with CCC issuance 21.5% of all high yield issuance, a figure not topped since 2008.  The 2nd quarter's CCC issuance jumped to 25.9% of total high yield issuance, a figure only second to the all-time record in 2007.  The five-year cumulative mortality rate for CCC's is 47.4%, a sobering statistic given the amount of low-rated debt issuance since 2010.  46% of the 1st half high yield issuance was Cov-Lite, another factor which typically results in lower recovery rates should the debtor company default.  Dr. Altman's well-known Z-Score metric, which quantifies a company's probability of default, shows that the credit quality of companies in the peak of the current cycle is lower than that of the last cycle peak in 2007.  

Marty Fridson's recent study suggested that the next default upsurge may be $1.576 trillion of face value between 2016 and 2020, a startling prediction given high yield's lofty status, which on average continues to trade well above par.  The price of weak credits typically fall well before the default rate spikes.  As an example, we point to 2007 and 2008 where the default rate was below 2% for every month except December 2008.  By the time the big spike in defaults occurred, the recovery (and QE) were already well in place.

    

  

Please enjoy your Labor Day and be safe.  I will be in NYC tomorrow for meetings if you'd like to meet, and I'll be at Citi Field for a Goldman event on Thursday (followed most likely by the US Open) if you'd like to catch up then.  We look forward to speaking with most of you in further detail about the current opportunity set throughout the next few months.  

Richard Travia

Director of Research