FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 26 Aug 2014

Comment:

The yield curve shifted in a non-parallel fashion last week (Tuesday to Tuesday) with the 5yr increasing 3 bps and the 10yr falling 3 bps to yield 2.40. The 5/10 spread consequently flattened 6bps for the week ending at 74 bps. Curve flattening typically drives mortgage rates lower, thus increasing refi incentives. Moreover, mortgage rates began to decrease this week and showed higher correlation with Treasury rates. These notions vindicate the 14-point increase in the refi index and the wider IO OAS week-over-week. The cuspy benchmark 4s of 14 IO widened 7 bps despite implied vol on the 1MX10YR swaption decreasing 8bps.

Lower vol and outright purchases drove the mortgage basis tighter 8 bps to 148 bps over the 5yr. Discount FNMA 3s performed the best of the stack ending tighter 21 ticks this week. The street maintains the view that the MBS curve is working its way out of up-in-coupon swaps, driving better performance in discount MBS vs Treasuries.

Issuance remains elevated this week as the total 5-day moving average this week was $1.59 bln, compared to $1.62 bln, $1.43 bln, and $1.45 bln for the weeks ending August 19, August 12, and August 5, respectively. Increased issuance and Fed tapering continue to bias our negative outlook on the basis.

Noteworthy:

FHLMC issuance increased significantly last week as a portion of 30-year conventional issuance. For the week ending August 19, FHLMC issuance was 48%, while this week it was 80%. Slightly better fungible execution partially explains the boost in Gold issuance week-over-week.

Have a Happy Labor Day,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: The Consumer is Dead (Tired)

As we turned the page from July to August, and the technical selling of high yield bonds slowed and then turned, I started to re-think about fundamentals (and a partially sensational subject line!).  Retail sales was reported on August 13th, and the results showed the worst month-over-month change in six months (0%).  There continues to be a large disconnect between headline unemployment (which has steadily improved), and signs of momentum or enthusiasm from the consumer.  Without an incredibly strong consumer, 3rd and 4th quarter growth will not meet the lofty expectations that have been set.  

As headline unemployment moves its way towards 6%, there has not been meaningful growth in hours worked or wages earned, two factors incredibly important to a consumer that is already fragile and doesn't believe that there is minimal inflation.  In the last 10 years, according to the BLS, regular unleaded gasoline has risen in price by 57%, white bread has risen by 32%, ground chuck beef has risen by 54%, eggs have risen by 67%, milk has risen by 18% and electricity has risen by 36%.  These price rises in staples pale in comparison to the nearly 80% rise in the cost of a college education over that same time period.  Compare this with an average annual inflation rate of less than 2.5%, and it is easy to understand why consumers aren't showing up at malls, why they will easily and readily seek out discounted prices and why they have little patience for a less than optimal product or service.  The consumer is tapped out and investor patience is wearing thin...

Disappointing earnings reports for retailers started on the week of August 11th, with Macy's and Nordstrom surprising the market.  Both are known for their strong management teams and for their consistent results, but decreased mall traffic, increased need for promotions, internet competition and tighter margins caught investors offsides.  Guidance wasn't any better, with Macy's CEO Terry Lundgren warning that, "Many customers still are not feeling comfortable about spending more in an uncertain economic environment."  Subsequent earnings reports in retailers, with much less respected management teams and less stellar track records of success, have been almost uniformly poor.  Wal-Mart, a company that is about as close to the average American consumer as possible, just reported its 8th consecutive quarterly decline or loss in same store sales.  

We are seeing very poor results and guidance from the companies we are short of.  And while technical selling may have temporarily reversed, with the the Wall Street Journal reporting earlier this week that "Big investors snap up junk bonds - Institutions take advantage of a recent slide in high yield bonds price triggered by small investors selling", the fundamental reality of the deterioration in credit quality continues.  Warning signs are everywhere, with the most recent being this weekend's interview with TCW in the Barron's.  Tad Rivelle and Laird Landmann, who manage $142 B, point to the end of the current credit cycle.  We agree, and think that technical and fundamental factors will spur a significant move in high yield over the medium term.

Enjoy your Sunday,

Richard Travia

Director of Research

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 19 Aug 2014

Comment:

Week-over-week, we saw mortgages underperform their 10yr hedge by 4-6 ticks largely driven by a risk-off move late last week on tensions in Eastern Europe and the Middle East.  In addition to the risk-off mentality, issuance picked up as summer originations have made their way into the secondary market.  In conjunction with the Fed’s taper and higher issuance, we remain neutral/bearish on the basis for the time being.

The Fed released its July meeting minutes on Aug 20^th and investors looked for indications of policy change.  The tone of the minutes was indeed more hawkish as “many members noted … that the characterization of labor market underutilization might have to change before long, particularly if progress in the labor market continued to be faster than anticipated.”  Following the press release, the 10yr sold off 8+ ticks to yield 2.43.  The curve continues to flatten as we approach the lowest 5-10 spread levels since December 2008.

This week, the refi and purchase indices continued to decline, easing fears of higher prepayments.  Despite diminished prepayment concern, increased volatility contributed to wider OASs on production coupon benchmark IOs.  For example, FN 4s of 13 were 7 bps wider, while 2011, 2010, and 2009 vintages were 1, 3, and 7 bps wider, respectively.

Noteworthy:

The GNMA II 3.5 Aug/Sep roll never converged to the GNMA II 3.5 Sep/Oct roll as we had anticipated.  The Aug/Sep roll remained around 7+ while the Sep/Oct roll has been trading around 10 1/8.  Supply/demand and anticipated prepayment dynamics likely caused the divergence.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 12 Aug 2014

Comment:

Week-over-week, the mortgage basis widened 1 bp on continued tapering and a slight uptick in volatility. Our fair value estimate of the yield spread between current coupon MBS and the 5yr is 157 bps, while the market closed at 158 bps on Aug 12. We expect the basis to widen another 10bps, and maintain a short position on an expectation of increased issuance and decreased Fed purchases. The middle of the coupon stack underperformed this week as 4s ended 2 ticks wider vs their 5yr hedges. On a positive note, roll markets are stronger this 48-hour cycle, with rolls trading at 11 _1/16 for 4s and 10 _5/16 for 3.5s on August 12^th.

Our position in the G2 3.5 fly has appreciated 3 ½ ticks this week, and we continue to look for further appreciation.

The Refi and Purchase indices dropped 60 and 4 points, respectively, helping to ease prepay concerns as rates continue to trend downward. The benign prepayment environment, declining volatility, and the reach for yield have helped IOs hold up despite the trend in rates.  Additionally, hedged carry remains high, with 3.5s of 2012 at 5 ticks per month. Although at historic highs, IO multiples have upside as prepayment fears are subdued and there are relatively few attractive investments in fixed income.

Noteworthy:

Market participants widely expect rates to climb due to an improving economy and Fed tapering. Despite these circumstances, the 10yr yield has fallen 55 bps from its December 2013 peak. A contributing factor to the rate decline is the wide rate differential between US Treasuries and European bonds as the ECB continues its dovish policy. Bill O’Donnell, head of US Government bond strategy at RBS, summed up the phenomenon in a Bloomberg interview: “The path to higher rates, which we expect in the near term, is going to remain a challenging one just because rates are going to remain low in Europe for a long time and our interest-rate differentials are already pretty wide.”[1]  The current 15 bps of yield spread between Spanish and US 10yr bonds vindicates O’Donnell’s statement.  Rates may continue to fall given foreign demand for Treasuries.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

---

[1] http://www.bloomberg.com/news/2014-07-03/treasuries-decline-as-u-s-employment-growth-accelerates-in-june.html

FLASH UPDATE: Technicals First, Fundamentals Second

According to RBS, retail investors now own an astounding 37% of the credit market.  This has grown from 29% in 2007, significantly in conjunction with the growth of mutual funds and ETFs.  As I have discussed in this blog over the last few weeks, the liquidity in the market has not kept pace with the relentless demand for yield.  Off the charts issuance in the primary market has created a complete misconception about perceived liquidity in the secondary market, where high yield bonds actually trade.  

While US bond fund assets have grown from approximately $1 trillion in 2003 to nearly $4.1 trillion today, dealer inventory has fallen off a cliff.  Peak inventory in early 2008 was nearly $250 billion.  Today, US corporate dealer inventory is $61.7 billion, with average daily trading volume in US corporates dipping below 2% of all outstanding debt for the first time since the late 1990's.  Specifically, high yield corporate inventory fell to $4.8 billion in early July, the lowest level since the Fed started publishing this data in April 2013.  

Banks have been forced to eliminate or repurpose most of their prop-desks and their risk-taking activities have been largely curtailed.  Post 2008 crisis, banks now face must stricter capital requirements, where the appetite to hold the riskiest securities on their balance sheet is suppressed.  Market participants are finding out fast that the bid is difficult to hit when selling bonds, even in small size.   

For the week ended August 6th, investors pulled a record $7.1 billion from US junk bond mutual funds and ETFs.  In the last four weeks, the redemptions have totaled $12.6 billion, trumping the $12.3 billion pulled in Q2-2013's "taper tantrum".  The high yield bond market, which typically trades with a very high correlation to the stock market, is starting to diverge.  The overheated credit market and its growing bubble have now gotten the attention of the media, with daily headlines suggesting caution.  With interest rates set to move higher, taper almost complete and QE being wound down, high profile investors and economists are letting themselves be heard by sending out warnings.  Corporate bankruptcy expert, Dr. Ed Altman, published research earlier this week which discusses the nature and risks in the current credit bubble.  For full disclosure, Dr. Altman is an advisor to our Fund.

Let us also not forget the following:  1) There are serious military actions occurring in the Middle East as we speak - that the US is now involved in, 2) several airplanes carrying innocent civilians have recently either mysteriously disappeared or have been shot down, 3) the Fed recently announced that inflation is unlikely to continue running below the 2% target, 4) the 2nd largest bank in Portugal just effectively collapsed, and 5) Argentina just had its 2nd technical default in the last 15 years.  In the summer of 2011 (the last real market correction), the S&P 500 fell nearly 20%, primarily on a spike in anxiety about Europe's ongoing sovereign debt crisis, specifically with Greece teetering on the edge of default, and the US government's inability to agree on the debt ceiling, which ultimately resulted in a credit rating downgrade.  

We are facing an environment where market technicals can turn very quickly, both for the positive and negative.  While I have consistently written about, and discussed with most of you, that the poor fundamental health in many of the B and CCC-rated bonds we are short of will be the ultimate driver of downward bond prices, the technical considerations in the market are quite important and compelling today.  I urge investors to seriously consider adjusting their exposures, to be proactive rather than reactive and to take advantage of the asymmetry present in being short high yield today.  

Enjoy your Sunday.  I'm in the Pocono Mountains with my in-laws - fishing, playing with the dog, watching the kids play, but thinking about high yield bonds!!! 

Richard Travia

Director of Research

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 05 Aug 2014

Comment:

The mortgage basis widened 6 bps last week as Treasuries rallied on continued geopolitical risk.  The street forecasts the basis to widen another 10-12 bps and maintains a tactical short position owing to the Fed’s taper trajectory and weakening rolls.  Basis trades hedged with the 5yr fared substantially worse than those hedged with the 10yr as the yield curve steepened 3 bps last week.  Additionally, premium coupons outperformed discounts, with FNMA 4.5s selling off 1 tick and FNMA 3s selling off 11 ticks vs 5yr hedges.

On the supply side, the 5-day moving average of net origination sits at 1.45 bln and has been ticking upward over the past few weeks.  Summer seasonals and higher rates July’s conclusion partially explain the uptick in origination.  As a case study, 10yr yields closed 11 bps higher on July 31^st as origination came in at 2.2 bln.

Despite lower rates over the week, the refi index closed 5 points lower at 1377 and the purchase index closed 2 points lower at 167.  The rates rally has not been large enough to spur a renewed refi wave.  Furthermore, burnout may be a contributing factor to the decline in the refi index.

Noteworthy:

The FNMA 3.5 roll has come off special as the breakeven finance rate sits at 0 bps at a roll price of 9 ticks and a projected 1M CPR of 3.9.  Be cognizant of recent prepayment prints as they will impact roll specialness: premium specialness will increase from fast prints while discount specialness will increase from slow prints.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: TRV Weekly Commentary

TRV Weekly Commentary
Week Ending 29 July 2014

Comment:

The mortgage basis tightened 4 bps last week to 149 bps over the 5yr yield. The street continues to promote tactical long positions in the basis for the short term. Lower coupons continued to be the best performers this week as FNMA 3.5s were up 10 ticks vs their 5yr hedge. Despite recent performance, we are still not constructive on the basis due to lower Fed purchases and an expectation of increased supply over the next few months. We also expect lock desks to short TBAs as rates rise, which could place further pressure the basis. Our regression model suggests that the fair value spread to 5yr yields is 150 bps.  Sitting at 149 bps, 1 bps of widening to our fair value estimate translates to 2 1/8 ticks widening on production coupons. We continue to seek alternatives to the basis to provide sources of alpha.

One potential opportunity is to buy the GNMA II 3.5 Roll. We saw a relatively high prepay print last month due to servicer buyouts of GNMA collateral. The market continues to penalize the roll (currently at 7 ½ ), but we believe a long position will benefit as prepays slow.

On the prepayment front, the refi index fell 56 points this week, and the purchase index remained flat. Low prepayments and expectations of rising rates has kept IO OASs tight, and we hold this expectation going forward.

Noteworthy:

On July 24th, we saw a strong initial jobless claims print (284 vs 307k) and 10yr yields increased above 2.50.  The Fed continues to make dovish statements, but there is gathering support for the hawks.  The strong GDP print (4% annualized) on the 30^th furthered this notion, as the 10yr backed up 9bp and origination hit $2.2 bln.  After a few false starts, it will be interesting to see if we reach a turning point in rates.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: Junk Bond Investors Starting to Sense a Tide Change

High yield bonds saw their first significant spread widening in a very long time during the month of July.  Headline pressure is now starting to feel more common place, as most well respected newspapers are regularly reporting about the potential for a problem in the high yield market.  Junk bonds had continued their unabated rise in price and fall in yield until July, but now that a limitless fear is in the system we are thinking about what might be a catalyst to trigger a more significant and painful (for many investors) sell of in corporate high yield debt.  

As last week's FT and WSJ regularly pointed out, there seems to be more than just a 'growing concern'.  It seems that this 'growing concern' has crossed over into the 'growing fear' category, a distinction that I'm sure no one can articulate.  What is easily deciphered, though, is the outflows from junk bond funds - $1.48 B weekly through Thursday - a signal that could cause retail investors to rush for the panic button.  

A few weeks ago, I brought up the potential for an issue related to HY ETF and Mutual Fund redemptions.  Once selling pressure starts, it will be difficult to contain.  Recognizing this, the Fed has started discussing behind the scenes the possibility of exit fees, which of course would very much change the nature and tone of the market.  I briefly discussed the liquidity mismatch between what retail investors expect from these vehicles and what is real in the underlying securities.  The underlying securities can quickly become less liquid, something that we've seen before.  Once that occurs, and selling pressure builds, bid/ask will certainly widen and the HY problem will be exacerbated.  He liquidity concerns have been well documented, but less thoroughly reported (perhaps they have been suppressed).  Earlier this year the IMF put out a special stability report which pointed to this as becoming a potential systemic event.  

We will watch this closely, as we do with all other signals of stress in the HY market.  Please feel free to reach out if you'd like to discuss this in further detail.

Enjoy the rainy Sunday,

Richard Travia

Director of Research